capital market reforms
TRANSCRIPT
PROBLEM & ITS BACKGROUND
1.1 INTRODUCTION
A modern and efficient capital market is the backbone of an economy. It plays a
crucial role in mobilizing domestic and foreign resources, and channeling them to
promote investment activities both for the short and the long-term periods. No country
can prosper without developing its equity market (Rizvi, 2002).
Reflecting upon the Asian currency crisis, more attention is being paid to the
importance of consolidation for the domestic financial and capital markets, as well as
international cooperation to avoid disturbing factors from abroad, such as massive
inflows of speculative capital (Kishi, 2002).
The government of Pakistan and its respective regulatory agencies has been
striving hard to tame negative speculations, restore investors' confidence and stabilize
stock market for the last many years and numerous regulatory, financial and other
corrective measures have already been taken to obtain these objectives. But even then, by
the end of 1997, the index was at the bottom, market was vacillating between the spell of
greed and gloom, investors were living in the state of despair and the country's financial
image had been shattered. The market mechanism has not been working under the
principle of demand and supply, as well as the economic fundamentals for as long as can
be remembered (State Bank Report, 2000).
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The Capital Market in Pakistan has two main components: an Equity market
represented by the three stock exchanges in Karachi, Lahore and Islamabad; and an
intermediated financial system dominated by an increasing number of Non- Bank
Financial Institutions (NBFIs).
In the development of its capital markets, Pakistan has faced issues similar to
those in other emerging markets in Asia. But the economic turmoil presents Pakistan with
some unique problems. The downturn in the capital market dates back to late 1994. After
several attempts to address the country’s macroeconomic imbalances and deep-rooted
structural problems, shortcomings in policy implementation came to light, bringing the
country to the brink of a foreign exchange crisis in October 1995. Between the end of
1995 and April 1998, the rupee depreciated by 24 percent. Since 1995, the threat of
currency de-valuation has deterred foreign portfolio investment. From 1996 onward,
deteriorating law and order in Karachi, the Government’s prolonged tussle with foreign
independent power producers (IPPs), and the constitutional crisis in late 1997 all
dampened growth of the capital market. In March 1998, the withdrawal of tax exemption
granted to corporate holders of Term Finance Certificates (TFCs) also hit the corporate
bond market (Chou, 1998).
The country has already achieved a moderate level of capital mobilization through
the bond and equity markets at 43 and 22 percent of gross domestic product (GDP),
respectively, at the end of 1997. However, the figures are deceptive as government issues
dominate the corporate bond market—with corporate bonds accounting for only 1 percent
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of GDP. Similarly, the equity market became more skewed from 1996-1998, resulting in
the top five stocks representing more than 70 percent of market capitalization by May
1998.
Finally, in the aftermath of the nuclear tests of 28–30 May 1998, austerity
measures were imposed. With the freezing of foreign currency accounts and sanctions
imposed by G-8 countries, activities in the foreign exchange market almost ground to a
halt and so did foreign portfolio flows. The currency plunged in the market amid fears of
an impending debt default. Under the threat of a recession, the bond and equity markets
received a grave setback. The negative market sentiment was reflected in the decline of
the key Karachi Stock Exchange (KSE)-100 index, which plunged 56 percent during
1998, reaching a record low in July of that year (Chou, 1998).
The first vital step taken by the government to counter all these problems was the
dissolution of Corporate Law Authority in 1997 due to its total failure to manage the
stock market and the involvement of some of its bosses in financial bungling.
Constitution of the Securities and Exchange Commission of Pakistan (SECP), an
independent and powerful regulatory body to purge rotten system, create level-playing
field and bring all stakeholders under a new regulatory framework was another step in
this regard. The establishment of the Central Depository Company (CDC) was also a
milestone in the corporate history of Pakistan aiming to create transparency in trading,
eliminate the trading of fake shares and facilitate electronic transfer.
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The Asian Development Bank (ADB) planned to substantially reform Pakistan’s
securities market with the help of two loans totaling US$255 million approved in
November 1998 for the Capital Markets Development Program (CMDP) (ADB, 1997).
The ADB provided one policy loan of US$250 million for reforms intended to
strengthen the regulatory and institutional frameworks to improve investor confidence,
eliminate market distortions and modernize and upgrade the securities market
infrastructure. The ADB also provided a concessional technical assistance loan of US$5
million equivalent for capacity building to implement the reforms. Repayment of the
policy loan is over 15 years, including a grace period of three years. The ADB’s technical
assistance loan is from the Asian Development Fund (ADF), the Bank’s concessional
fund. The loan is interest-free and carries a service charge of 1 percent per annum. This is
repayable over 40 years, including a grace period of 10 years (ADB, 1997).
The capital market reforms are an integral component of the structural reforms
being supported by the International Monetary Fund to restore macroeconomic stability
and to build up the banking system, while developing a more conducive incentive regime
for industry. The ADB program builds on this.
Pakistan needs to develop its securities market to enhance resource allocation and
to broaden and deepen the financial sector while at the same time providing alternative
funding sources to industry, which has had to rely on Government-directed credit.
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The stock market has been hampered by weak infrastructure and regulatory
restrictions on institutional investors who are required to invest a large proportion of their
funds in Government securities. Key market participants such as mutual funds, insurance
industry and leasing companies are prevented from playing a full role in the capital
market by constraints such as tax anomalies, a predominance of the public sector and
regulatory weaknesses.
Market discipline and stability will be enhanced by the creation of a regulatory
body, an independent Securities and Exchange Commission of Pakistan (SECP), to be
operational by December 1998. The CMDP will eliminate repressive regulations and tax
laws that have stifled growth of the equity and debt markets, with key initiatives to be
effective in July 1998. These include the reduction of corporate tax rates for public and
private limited companies, easing investment restrictions on institutional investors, and
rationalizing the tax structure for private debt securities and mutual funds. The Ministry
of Finance will be the executing agency for the policy loan and the SECP for the
technical assistance loan. The Securities and Exchange Commission of Pakistan (SECP)
has accelerated its drive to enhance the efficiency of the stock exchanges, ensure
protection of the interest of investors and supervise the implementation of the reforms
advised by the ADB.
In short, Pakistani stock markets are on the road to better performance and
efficiency. Although their volatility - an essential part of all emerging markets, creates
higher risks they also magnify the potential for higher returns for any investor who has
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the patience and sophistication to participate in the growth of this emerging market
(Thaplawa, 2001).
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1.2 RESEARCH QUESTIONS
This project aims to answer the following questions:
What are the reforms proposed by the Asian Development Bank as part of its
capital market development program?
What is the aim of ADB behind these reforms?
How far has the Government of Pakistan worked to implement these reforms?
Whether the Securities Exchange Commission of Pakistan has faced any problem
during the implementation?
What is their effect on the capital market in Pakistan?
Have the reforms been executed in their true spirit?
Have the support institutions like stock exchanges been supportive of the
reforms?
Which reforms have not been executed so far?
What are the reasons behind the non- execution?
Will the reforms be applied in the near future?
1.3 OBJECTIVE OF THE STUDY
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The objective of this research study is as follows:
To understand the aims and objectives of the reforms introduced by the Asian
Development Bank in the recent years.
To study the implementation process conducted by the SECP (Securities
Exchange Commission of Pakistan).
To understand the areas these reforms intend to target so that a critical analysis
can be conducted so as to compare and contrast the target areas before and after
the restructuring.
To find out if the implementation is according to the expectations of the
government and ADB.
To study speculations surrounding the changes.
To find out whether the changes being carried forward are in fact positively
affecting the operations of the capital market and how can the process of change
be improved, if possible.
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1.4 SIGNIFICANCE OF THE STUDY
A research on “A critical analysis of the capital market reforms introduced in
Pakistan” is significant for understanding the various changes taking place in the
Pakistani capital markets over the years since Asian Development Bank proposed its
reforms.
Capital market in Pakistan has experienced many ups & down in the past, due to
frequent changes in the government and their policies relating to capital market. The
equity market of the country had to survive in an atmosphere of uncertainty, which had
mainly impacted the performance of the stock market in the 1990s (Rizvi, 2002).
This study will give an in depth scrutiny of what has already been accomplished
and what are the reforms’ implications, so that the people can believe the multi- pronged
operation to cleanse the corporate sector specially with view to protect the interest of
small investors and thereby restore their confidence in the stock markets. A policy
environment can be created for enhancing competition and level playing. Most of the
people in Pakistan are unaware of the working of the capital market and its significance
in the economy of a country. This research will be an important step towards educating
them about the various aspects of the capital market and how they can be effective
participants in the economic development. Different aspects of these reforms aimed at
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improving the capital market have been highlighted and explained as to how they are
effective and how investors can take advantage of them.
SECP has managed to implement 30 principles of International Organization of
Securities Commissions (IOSCO) that conform to international standards of securities
market under the capital market reform program of the government in collaboration with
the ADB, (Mirza, 2001). The significant improvement in the working of capital markets
has been noticed both within and outside the country and any critical material on this
topic is encouraged and published as well.
The results obtained from this study can help the reader in getting a better
understanding of the operations as well as the various factors (financial and non-
financial) affecting the working of the Pakistani capital market. The impact of the
reforms introduced in 1997 by ADB and implemented by the government of Pakistan and
the level of success of these reforms in regulating the capital market and making it an
attractive but safe venture for the investors, both domestic and foreign can also be
understood.
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1.5 SCOPE & LIMITATIONS OF THE STUDY
The subject/ content of the study is to analyze the capital market reforms
introduced in Pakistan and their far-reaching effect once implemented. In order to make
this research specific, the focus will be on the reforms introduced by the Asian
Development Bank in 1997 and the activities of the Securities Exchange Commission in
this regard. The time frame of the study covers six months, from March- August 2003.
This study is challenged by certain factors, namely costs, time and scope. The
study is aiming to cover the reforms introduced for the development of the capital market
in Pakistan by ADB and Government of Pakistan. This is a broad topic and as such
covering each aspect of the reforms in detail will prove to be a difficult task since the
time and the information available may prove to be a serious limitation.
There will be a limitation in terms of skill and education of the researcher, which
still lacks sophistication and advancement in the understanding of the intricacies of
finance and economics. Therefore the analysis may not be as professional as it can be.
However, maximum efforts will be exerted to ensure authenticity and proficiency.
Another limitation that can prove to hinder the researcher is the problem of
accessing the related research articles and journals. The student has to depend on outside
sources for information and encounters many tribulations in actually collecting the
information. 11
1.6 DEFINITION OF TERMS
Bearish Trend: A falling market, characterized by selling a security in hope of buying it
back at a lower price.
Blue Chip: A large, well-established company with a history of profitable operation.
Bonds: Fixed- income securities, which entitle the holder to a pre-determined return
during their life and repayment of principle at maturity.
Bullish Trend: A rising market, characterized by buying a security in the hope of selling
it later at a higher price.
Capital market: Markets in which longer-term financial instruments, debt and equity
instruments i.e. bonds and shares, stocks are traded. Capital market consists of the
institutions through which savings in the economy are transferred to investors. Stock
exchanges, saving banks, investment banks and insurance companies are a part of capital
market.
Carry-over Trades: Equity repurchase transactions, better known as “Badla”, these are
an established form of transactions used in the stock market for temporary financing of
trades by speculators and jobbers.
Dividend: That part of a company’s profits which is distributed among shareholders,
usually expressed in rupee per share or percentage to paid up capital.
Equity: The owner’s interest in a company’s capital, usually referred to by ordinary
shares.
Financial Markets: Financial Markets are all institutions and procedures for bringing
buyers and sellers of financial instrument together.12
Initial Public Offering (IPO): The offering of equity shares of a company to the general
public for the first time.
Insider Trading: The purchase or sale of shares by someone who possesses “inside”
information on a company’s performance which information has not been made available
to the market and which might affect the share price. In Pakistan, such deals are a
criminal offence.
Investment Companies: A company, which issues shares and uses its capital to buy
securities and shares in other companies.
Listed Company: A company whose securities are admitted for listing on a stock
exchange.
Market Capitalization: The total value of a company’s equity capital at the current
market price.
Option: The right (but not the obligation) to buy or sell securities at a fixed price within
a specific period.
Portfolio: A collection of Investments.
Primary Market: Where a company issues new shares, either for the first time, or at the
time of issuing additional securities.
Privatization: Conversion of a state owned company to a public limited company (plc)
status.
Private Company: A company that is not a public company and which is not allowed to
offer its shares to the general public.
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Public Limited Company: A company whose shares are offered to the general public
and traded freely on the open market and whose share capital is not less than a statutory
minimum.
Rights Issue: The issue of additional shares to existing shareholders when companies
want to raise more capital.
Securities: A broad term for shares, corporate bonds or any other form of paper
investment in capital market instruments.
Settlement: Once a deal has been made, the settlement process transfers stock from seller
to buyer and arranges the corresponding exchange of money between buyer and seller.
Short Selling: The act of borrowing stock to sell with the expectation of price reduction
with the intention of buying it back at a cheaper price.
Stock Broker: A member of the stock exchange who deals in shares for clients and
advises on investment decisions.
Stock Market: The market place where shares of publicly listed companies are bought
and sold.
Yield: The aggregate return earned on an investment taking into account the dividend/
interest income and its present capital value.
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LITERATURE REVIEW
In the inward-looking era of the 1950s, most countries’ domestic financial
systems labored under extensive government restraint and were cut off from international
influences by official firewalls. Despite these restrictions, which were a legacy of the
Great Depression and World War II, international financial crises occurred from time to
time. Between 1945 and 1970, however, their effects tended to be localized, with little
discernible impact on Wall Street, let alone Main Street. Over the past twenty-five years
or so this has all changed dramatically. Regional financial crises seem to have become
more frequent, and the domestic impact of global financial developments has grown, to
the alarm of many private citizens, elected officials, and even economists (Bacha, Lisboa,
and Alejandro, 1982).
Thus, the scope for capital markets to do good-or do harm-loomed larger as time
went by. As an ever-greater part of national and international economies became
monetized and sensitive to financial markets, agents in all spheres-public and private,
labor and capital, domestic and foreign-were affected (Sylla, 2000).
The relationship between financial development and economic growth is an issue
that has also generated intense controversy; most theoretical expositions suggest that a
well- functioning stock market can significantly influence industrial growth rate. But
there are disagreements as to the direction of the effect on growth. While some
development economists argue that financial development has little or no effect on
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growth, others predict a strongly positive link between economic growth and financial
development. However, there is little disagreement that a well- functioning market
guarantees liquidity, risk diversification, acquisition of information about firms, corporate
control and savings mobilization. Certainly, any changes in these factors will alter the
rate of industrial growth (Udegbunam, 2002).
For these reasons, the argument of those proposing a positive link between
financial sector performance and economic growth appears more convincing. Financial
development spurs higher economic growth by mobilizing savings. (Greenwood and
Jovanovic, 1990) show how a well-developed financial sector can enhance economic
growth by pooling savings. In particular, a well functioning stock market provides
finance for long- term risky, but high return industrial projects rarely financed by other
financial markets. This is because the stock market can pool together long- term funds
needed for such projects; pooling of resources provide diversification, protects savers
from idiosyncratic risk, and enables the stock market to fund lumpy and risky, though
profitable, long term industrial projects (Montiel, 1995).
A well-developed stock market promotes efficient allocation of the accumulated
savings. The financial sector plays a role in channeling resources towards more profitable
projects, or better investment opportunities (Becsi and Wand, 1997). By allocating
resources more efficiently to profitable long- term investments, the stock market
increases productivity in the real sector (Udegbunam, 2002).
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Another role of a well- functioning stock market, or financial system as a whole,
is its ability to guarantee adequate liquidity. That is, investment in long term, high- return
projects will be almost impossible without a liquid stock market or financial system. This
is because savers may be willing to relinquish their funds if they are not assured of
prompt and easy access to their savings when needed. A highly liquid stock market
makes it possible for portfolio investors to acquire financial assets, and this enables firms
to have access to long- term funds. The investors are encouraged to invest in these assets
because they have access to their savings throughout the investment period. Thus a liquid
stock market enhances investment in profitable projects with prospects for long-term
growth (Bencivenga, 1996).
A well- developed stock market also reduces investment risk by offering
opportunities for portfolio diversification. The availability of different investment
opportunities with differing risk characteristics encourages savers to acquire diverse
investment assets, as this ensures minimum risk exposure (Levine, 1991).
A well- functioning stock market improves corporate control, monitors managers,
and stimulates information acquisition about firms. Ythe incentives for investors to obtain
information about firms and improve corporate governance can be substantially increased
by a developed, highly liquid stock market. When a stock market is liquid, an investor
can use information acquired to trade quickly and easily at posted prices. The profit from
such information will further spur investors to embark on supervision and monitoring of
firms (Kyle, 1984).
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Capital markets play a crucial role in mobilizing domestic and foreign resources,
and channeling them to the most productive medium and long-term uses. Stock market
development is positively associated with economic growth. (World Development
Report, 2001). The importance of the stock market in the general equilibrium of the
financial market has been duly recognized (Tobin, 1969). Moreover, a strong connection
has been indicated between the predetermined component of stock market development
and economic growth in the long run (Levine and Zervos, 1996).
There is a close, if imperfect, relationship between the effectiveness of an
economy's capital markets and its level (or rate of growth) of real development. This may
be because financial markets provide liquidity, promote the sharing of information, or
permit agents to specialize. As the efficiency of an economy's capital markets increases
(the transaction costs fall), the general effect is to cause agents to make longer-term ---
hence, more transaction-intensive --- investments. The result is a higher rate of return on
savings and a change in its composition. These general equilibrium effects on the
composition of savings cause agents to hold more of their wealth in the form of existing
equity claims and to invest less in the initiation of new capital investments. As a result, a
reduction in transaction costs can cause the capital stock either to rise or fall
(Bencivenga, Smith, and Starr, 1995).
There is a statistically significant negative correlation between stock market
development to firms' total equity. For certain developed markets, further stock market
development leads to a substitution of equity for debt financing. In developing markets,
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by contrast, large firms become more leveraged as the stock market develops, whereas
the smallest firms appear not to be significantly affected by market development
(Demirgüç-Kunt and Maksimovic, 1995). However, the assumption that shares in the
stock market are considered to be perfect substitutes for bonds is not acceptable in the
case of many emerging market economies, where domestic bond markets for foreign
investment do not exist (Oblanchard, 1981).
If equity markets are financially integrated, the price of risk should be the same
across markets. If the markets are not financially integrate, possibly because of barriers to
capital flows across markets, the price of risk may differ across markets. Large values of
adjusted mis-pricing occur around periods of economic turbulence and periods in which
capital controls change significantly. So, the adjusted mis-pricing estimates measure not
only the level of deviation from the law of one price, but also the revaluations inherent in
moving from one regime to another (Korajczyk, 1995).
With public listed stocks, one can quantify the ownership mix and concentration,
which makes it possible to study whether ownership structure significantly affects the
performance of publicly, listed firms. There is a positive, significant correlation between
concentration of ownership and profitability. The effect of concentrated ownership is
greater with companies dominated by institutions than with those dominated by the state.
A firms' profitability is positively correlated with the fraction of legal person
(institutional) shares; it is either negatively correlated or uncorrelated with the fraction of
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state shares and with tradable A-shares held mostly by individuals. Labor productivity
tends to decline as the proportion of state shares increases (Xu and Wang, 1997).
Weak institutions—tangled laws, corrupt courts, deeply biased credit systems, and
elaborate business registration requirements—hurt people and hinder development.
Without effective institutions, people and developing countries are excluded from the
benefits of markets. Countries that systematically deal with such problems and create
new institutions suited to local needs can dramatically increase incomes and reduce
poverty. These institutions range from unwritten customs and traditions to complex legal
codes that regulate international commerce (Ryou, 2001).
The financial reporting and disclosure problems, as well as the high market
valuations for stock raise troubling questions about the functioning of capital market
intermediaries, regulators and governance experts whose are supposed to ensure the
effective functioning of the stock market (Healy and Palepo, 2002).
The history of financial development has left behind a lot of lessons for today.
Low inflation and sound public finance --- is important for creating the right incentives
for facilitating the development of securities markets. High inflation and large fiscal
deficits distort economic behavior in favor of short-term speculative projects and
discourage the long-term investment projects conducive to sustainable economic
development. Central bank independence may contribute to economic stability. One way
to increase it is by lengthening the term of central bank governors. Developing effective
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supervision (to ensure meaningful and effective compliance with prudential rules) is
difficult and time-consuming but essential (Caprio, Jr. and Vittas, 1995).
Two centuries ago, U.S. was a small, undeveloped country with serious financial
problems. The British stock market did better than the U.S. market until the United States
adopted security-market regulation (including disclosure rules) under the SEC. Then the
U.S. market became a world leader. The U.S. stock market developed more slowly than
the bond market, but it both aided and benefited from foreign investment in U.S. bonds.
Foreign investors preferred debt securities to equities, yet equities create a safety margin
for bondholders who, because of this margin, are more willing to purchase and hold
bonds. Foreign investors preferred bonds; U.S. investors, after exporting bonds, held
more stocks than bonds at home because good stock markets permit the conversion of
equity securities into cash (Sylla, 1995).
Looking at the experience of the financing pattern of the developed economies
like the US and the UK, it was found that the corporate sector in these countries has
followed a particular pattern of financing over the various phases of growth. In the initial
stages of growth (firm and economy), the firms followed a path of financing from the
external sources, mainly in the form of equity. But, with the expansion in the size and
increasing risk of take-over, the ‘insiders’ adopted a strategy of an increased dependence
on the internal (surplus) and external debt sources of financing. This pattern led to
increase in the debt (debenture/bonds and various other hybrid debt instruments). In the
latter half of 1980s, with the increasing significance of the emerging markets, there was
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relatively increasing role of capital markets in developing economies. This opened up a
new channel for sourcing investment fund for the firms. This new channel affected the
structure of industries in these economies (Dhar and Murali, 2001).
Financial systems in developing countries tend to be "restricted" or "repressed"
through burdensome reserve requirements, interest-rate ceilings, foreign-exchange
regulations, rules about the composition of bank balance sheets, or heavy taxation of the
financial sector. Governments are regulating the financial markets to the point of
financial repression (Denizer, Desai, and Gueorguiev, 1998).
Experience has illustrated the ability of financial markets to innovate to manage
risk exposures across markets and to circumvent official controls; it underscores the need
for national authorities in emerging markets to understand the limited effectiveness of
many restrictions that are being placed on financial transactions, lest institutions engage
in a variety of unobserved and unregulated transactions (World Bank Report, 1997).
Internal finance plays less of a role for Indian firms than for U.S. firms --- and
external debt a bigger role. This is consistent with theoretical predictions, given that
information and agency problems are less severe for Indian firms than for U.S. firms.
Findings for India, with respect to stock market's role in providing finance, are
generalizable to other developing countries. The development of stock markets is
unlikely to spur corporate growth in developing countries. Foreign investors have played
only a limited role in the slow-paced privatization of India's state-owned enterprises ---
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although in recent years, despite delayed reform of the securities market, foreign
institutional investors have begun to invest more. In emerging markets in Eastern Europe
and Latin America, foreign investors have played a much more active role in
privatization, chiefly by investing in those stock markets (Samuel, 1996).
Capital markets throughout Asia, the Middle East and the Americas have been
built and strengthened through (1) development and restructuring of regulatory agencies
and other related institutions (2) review and revision of securities laws and regulations,
(3) formulation of policies toward foreign and domestic resource mobilization, and (4)
implementation of human resource strategies for securities market professionals and
regulators (Aries group, 1999).
Reforms and innovations have been most effective when they meet these needs in
ways that are compatible with country conditions and increase access for the people.
Learning from the success and failures of other countries' experiences in institution
building can provide valuable guidance. But copying institutional models without
considering whether they are needed by those they are supposed to serve, and the
capabilities of governments and citizens, can waste scarce resources. For example, in the
early and mid-1990s, Gambia and Zambia tried to establish stock markets by building
stock exchanges and training people to staff them. However, there were so few listed
companies and so little trading that the exchanges could not generate the fees to be self-
sustaining. In hindsight, it is clear that conditions were not yet ripe for the creation of
stock markets and the effort would have been better spent on other needs, such as
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improving accounting and information systems (Ryou, 2001). In the development
business there is a tendency to label approaches that have worked well in one or more
countries as 'best practice' and then try to transplant these to other countries, When it
comes to institutions, one size doesn't fit all (World Development Report, 2002).
Development of the capital market includes establishing, strengthening and
restructuring securities market institutions (such as regulatory agencies, stock exchanges,
clearing and settlement organizations), intermediaries (such as investment banks, mutual
funds, leasing companies, venture capital firms, brokerage houses), and activities (such as
establishment of internal procedures and practices, development of appropriate
organizational and staffing structures, formulation of strategic initiatives, and the design
and implementation of customized management information systems). Existing securities
laws are reviewed and revisions are recommended to reduce fragmentation, the
enforcement powers of regulatory institutions are strengthened, and future use of new
financial instruments are provided for, including asset-backed securities. Assisting
regulatory institutions in drafting rules and regulations to cover all aspects of securities
market operations, such as information disclosure, securities underwriting, brokerage
activities, operations of mutual funds, margin trading, prudential safeguards, insider
trading, etc. Reviewing the self-regulatory framework for exchanges, and recommending
measures for improvement. Developing and conducting customized training programs
and human resource development strategies for regulatory agencies, self-regulatory
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organizations, and market participants, including investment advisors and broker/dealers
(Aries Group, 1999).
A limited supply of financial instruments is not a major obstacle to the creation of
pension funds and insurance companies. Such institutions build up their financial
resources gradually but steadily, giving reforming governments ample time to develop
securities markets. More important than the prior development of securities markets is a
strong and lasting political commitment to holistic reform: macroeconomic, fiscal,
banking, and capital market reform, as well as pension and insurance reform. So,
institutional investors can serve as a countervailing force to commercial and investment
banks, helping to stimulate financial innovation, modernize capital markets, enhance
transparency and disclosure, strengthen corporate governance, and improve financial
regulation (Vittas, 1998).
Capital market development in emerging markets encompasses a wide range of
activities, including institution-building, developing new instruments and mechanisms, in
addition to creating and improving legal and regulatory frameworks. On the institutional
side, it involves areas such as commercial and investment banking, insurance and pension
funds, rating agencies and bond insurance companies (financial guarantors), private
equity and venture capital, structured finance, derivatives, securitization, and securities
markets. To do capital market development effectively takes a broad range of tools
including debt instruments, guarantees, advisory and technical assistance work, equity
and quasi-equity (IDB, 2000).
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The dramatic improvement in the emerging markets over the past several years
has been stimulated by three factors. First, the search for higher yields—a key feature of
developments in mature markets—spilled over into emerging markets. As investors were
forced to move down the credit spectrum in order to maintain yields, there was a strong
increase in the demand for high-yield sovereign and corporate bonds issued by emerging
market countries. Second, the continuing drive by institutional managers to increase their
exposure to emerging markets and to achieve greater diversification of portfolios
provided an important stimulus for flows to emerging markets. Third, the clear
recognition by investors that the economic fundamentals in most emerging markets in the
1990s have vastly improved over those that prevailed in the late 1970s (IMF, 2000).
In the earlier period, many heavily indebted emerging market countries had
pursued development strategies based on import substitution, which involved using
capital inflows both to finance large fiscal imbalances and to offset the effects of cap-ital
flight. Fiscal imbalances often contributed to rapid inflation and a highly overvalued
exchange rate. By contrast, in the 1990s a broad set of emerging markets pursued a
strategy of opening their economies to international trade and capital transactions, fiscal
consolidation, inflation stabilization, and extensive structural reforms designed to
improve their economies’ overall efficiency (IMF, 2000).
Well-designed private sector transactions can play a key role in the capital market
development. Such transactions, with a high demonstration effect, contribute to
consolidating market reforms and shorten the emerging markets' learning curve, by
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transferring financial structuring know-how and market instruments from major markets
(IDB, 2000).
Open capital markets potentially bring enormous benefits to all-especially
developing countries. They can supplement domestic savings, encourage the efficient use
of scarce capital, and bring collateral improvements in know-how. But the Asian crisis
brought home the need for countries to take greater care in the way in which they
liberalize, especially if they lack sound financial systems. It is clear that liberalization has
to be done in stages, with due regard for the soundness of the financial market as a whole
(Ouattara, 1999).
A number of factors have helped propel private capital flows to the developing
capital markets. These factors included, first, the low level of interest rates and the
compression of corporate bond spreads, which prompted fixed-income investors in the
mature markets to move down the credit spectrum and search for higher yields on
emerging market debt. Second, improved economic performance in many emerging
markets reduced perceived credit risks. Third, institutional investors in the mature
markets continued to seek the benefits of portfolio diversification in the emerging
markets. Fourth, innovations in financial markets improved the ability of investors to
manage exposures and risks to emerging markets, increasing the attractiveness of such
investments. Fifth, continued financial and capital account liberalization in many
emerging markets encouraged inflows. Finally, improvements in the availability and
27
quality of information on emerging markets facilitated improved asset selection and
assessment (World Bank, 1997).
A remarkable development in the composition of external financing by
developing markets in the 1990s has been the increased reliance on bond issuance as
opposed to bank lending The favorable environment for emerging market borrowers in
global bond markets prompted several sovereigns to launch issues to restructure existing
liabilities at improved terms several entities placed century (100-year maturity) bonds,
including the People’s Republic of China, the Israel Electric Corporation, India’s
Reliance Industries, and the Endesa Chile Overseas Company. International placements
of equity by emerging market entities rose during 1996 but remained subdued compared
with the previous peak in 1993 (World Bank, 1997).
The role of capital markets is critical not only for the crisis-affected economies
but also for all vulnerable economies. The Asian crisis highlighted one important lesson:
short-term foreign capital cannot finance long-term projects. Domestic sources of long-
term funds are needed. However, long-term bond markets cannot be developed without
improved corporate governance or an expanded investor base. Until equity markets are
strengthened, the capital market cannot function well to complement the banking sector
(ADB, 2000).
Reflecting upon the Asian currency crisis, more attention is being paid to the
importance of consolidation for the domestic financial and capital markets, as well as
28
international cooperation to avoid disturbing factors from abroad, such as massive
inflows of speculative capital. The aim of the financial reforms being executed in the East
Asian countries, such as Japan, Korea and China, is to improve the managerial efficiency
of the business corporations and financial institutions (Kishi, 2002).
The crisis that consumed Thailand, Korea, and Indonesia was stemmed from
excessive credit expansion, financial sector weaknesses, and other structural
shortcomings. It then turned into a capital crisis, sparked by a massive outflow of funds
from these countries. This was a systemic problem, a crisis of the international financial
system. The problem was that the system had not yet developed enough to reconcile the
needs of all the participants—investors seeking new opportunities, emerging market
economies seeking resources for investment, and governments seeking to ensure that
markets were operating safely and efficiently (Ouattaram, 1999).
The existence of well-functioning securities markets would have reduced the
impact of the Asian crisis by enhancing the confidence of international investors, by
improving market discipline, by promoting more effective allocation of capital and
thereby reducing the incentives to withdraw from the market. Capital market
development might have reduced the heavy dependence on the banking sector and
foreign borrowing for project finance. The absence of well-functioning corporate bond
markets may have deprived the public of credit information generated by such markets on
a continuous basis. The lack of liquidity in the crisis-hit countries was further increased
by the low supply of investment-grade paper, the insufficient number of intermediaries,
29
and the high trading costs due to fixed brokerage commissions. Illiquid futures markets
may also have limited the hedging opportunities of market participants (Yoshitomi,
2000).
Malaysian authorities implemented controls on international capital flows late in
the Asian crisis, when most of the portfolio outflows had already occurred. The exchange
rate had depreciated sharply and was fixed at an undervalued level, making further capital
flight unlikely. The turnaround in the stock market, the return of positive GDP growth,
the building of reserves, and the relaxation of interest rates all coincided with the
imposition of controls. But the same changes took place in other crisis countries that did
not follow the same control policies. However, the controls provided insurance against
the consequences of possible further disturbances. They created a breathing space for
making needed reforms, and the authorities made good use of this time, stabilizing the
financial system and pushing ahead with regulatory and supervisory reform for the
financial sector and capital markets - a prerequisite for fully liberalizing the capital
account. Malaysia incurred a cost: an additional 300 basis point spread paid on floating
rate debt for a period after the controls were instituted. But the exit strategy has so far not
resulted in lasting flight of portfolio capital. Foreign direct investment remains below
pre-crisis levels, but it is not possible at this stage to attribute this to the effect of controls.
On balance, it appears that both the benefits from and the costs of the controls have been
modest, (World Bank Report, 2000).
30
The crisis in Thailand and in the Czech Republic have served as a reminder of
how quickly international financial markets respond to perceived policy uncertainties and
structural weaknesses, and the willingness of market participants to “test” the authorities’
ex-change rate commitment when weaknesses in policies are perceived (IMF, 1997).
A fundamental challenge in designing a well-functioning capital market design is
to overcome the adverse selection and moral hazard problems between managers and
investors, and between generations of investors. Financial disclosure regulations and a
complex network of intermediaries, such as corporate boards, auditors, financial analysts,
banks, investment banks, and fund managers, are created to mitigate these problems. An
embedded assumption is that these intermediaries themselves do not face serious
governance problem (Healy and Palepo, 2002).
Asia's developing countries have to work out long-term financial sector
development strategies that can prevent financial crises as well as lay a stronger
foundation for sustainable development. Critical here is the need to deepen and
modernize capital markets, particularly bond markets. This need is underscored by the
ongoing bank disintermediation, due to extremely guarded lending by both domestic and
foreign banks in the aftermath of the crisis. Massive strides in information technology
and economic and financial globalization also impel development of financial markets
(ADB, 1995).
31
DMCs need to diversify the sources of industrial financing through capital
markets. They need to modernize their method of corporate financing, which has
traditionally been overwhelmingly bank-based. Effective capital markets can help deepen
the financial base, lead to greater diversification of financing sources, and screen
financial risks more promptly than bank credit departments (ADB, 1995).
The capital market reforms are an integral component of the structural reforms
being supported by the International Monetary Fund to restore macroeconomic stability
and to build up the banking system, while developing a more conducive incentive regime
for industry. The ADB program builds on this (ADB, 1997).
These reforms will promote the long-term development of the domestic capital
market to enhance the country's ability to mobilize internal and external resources to
finance economic growth. It will also help improve the efficiency of allocating resources
by increasing reliance on market mechanisms. By promoting a more balanced market
structure, the reforms support self-sustaining growth in the sector, with investors and
issuers having equal access to the market. Various reforms vis-a-vis the development of
capital market will be addressed. These include the establishment of a framework for an
integrated national market system; modernization of the underlying support
infrastructure; further liberalization of the market by eliminating remaining impediments
to market growth; enhancing competition; and strengthening market regulation and
supervision (ADB, 1995).
32
The ADB has made enormous efforts to strengthen and modernize financial
sectors. Since as early as 1985, the ADB has been involved in comprehensive capital
market development work in Bangladesh, India, Pakistan, and Philippines. These
programs have aimed to strengthen equity markets, corporate bond markets, asset-backed
securities markets, mutual fund industries, investment banks, venture capital companies,
and institutional investors, through both public and private sector windows. The ADB is
currently helping to develop long-term debt markets in India and Thailand with a focus
on increasing the participation of pension funds, insurance companies and mutual fund
industries, and also on asset securitization (ADB, 1996).
In the wake of the financial crisis, Indonesia, the Republic of Korea, and Thailand
were provided with substantial assistance to help restructure their financial and corporate
sectors as well as restore the public's confidence in their financial markets. These
assistance programs helped the countries to adopt best financial governance practices,
increase the disclosure and transparency of financial information, and reform the legal
and regulatory framework governing corporate and financial sectors. Capital market
development is a key element of all these reform programs. ADB believes that these
programs and other assistance activities have significantly contributed to the stabilization
of financial and foreign exchange markets, the restructuring of capital markets and
banking sectors, and the ongoing economic recovery (ADB, 1995).
The reform program by ADB addresses the constraints to the stock market by
making the Securities and Exchange Commission an independent and credible watchdog,
33
by developing stronger market regulations and by bringing in modern systems such as an
automated central depository system and automated trading systems to integrate the stock
markets. The program also expands the limited number of securities by encouraging
divestment of government holdings in companies and privatization of state enterprises
and by establishing financial intermediaries to develop private debt and equity securities.
Institutional sources of capital will also be developed by liberalizing investments of
savings institutions, insurance companies, and pension and provident funds and by
opening up merchant banking and mutual fund operations to the private sector (ADB,
1997).
The Financial Markets and Governance Program (FMGP) at ADB, seeks to
support poverty reduction indirectly by facilitating growth and employment creation as
well as social protection. The immediate objective of the Program is to (i) strengthen
market soundness, stability and investor confidence through improved governance,
transparency and risk management; (ii) improved availability of and access to financial
instruments for savings and investment and related services; (iii) improve market
efficiency and attractiveness to issuers and investors, including institutional and foreign
investors. In the context of this program, non-bank financial markets will cover equity
markets, debt and money markets, contractual savings, and other non-bank financial
institutions and services including insurance, leasing and DFI reform (ADB, 2000).
Countries like India, Bangladesh and SriLanka, have also addressed key issues
concerning the growth and sustained development of the capital markets in the context of
34
the reforms introduced by the markets regulators and the Government. Introduction of
Capital Market Reforms aiming for stronger and vibrant markets, the structural and
conceptual factors that influence capital markets are usually taken into consideration. The
emerging challenges in the background of recent process of reforms and imperatives for
building a strong and vibrant capital market are reflected upon (Financial Daily, 2001).
The Reform program in India is promoting the long-term development of the
domestic capital market to enhance the country's ability to mobilize internal and external
resources to finance economic growth. It also helps improve the efficiency of allocating
resources by increasing reliance on market mechanisms. By promoting a more balanced
market structure, the Program supports self-sustaining growth in the sector, with
investors and issuers having equal access to the market (ADB, 1995).
Recent development projects by the Asian Development bank aim to address
deficiencies in the Indian and other Asian capital markets and support continuing
reforms. Among others: (i) define the options for regional stock exchanges in the context
of the emergent environment; (ii) examine whether alternative exchange platforms such
as Euro next would be a viable option in the Indian context, (iii) examine the
recommendations of the progress report and its impact on the role/operations of the
regional exchanges, (iv) examine whether the regional exchanges could undertake new
activities such as commodities trading, (v) define the process by which demutualization
could be efficiently implemented under proposed legislation, (vi) mitigate risks in the
35
introduction and trading of various forms of derivatives in the Indian market (ADB,
2003).
India is now fast moving towards being the benchmark in the international arena
in capital markets because of its several far-reaching reforms. The markets are monitored
daily on real time basis, which is not in existence even in developed markets, including
the US and UK, where it is monitored twice or thrice a day. Many stupendous reforms
have been taken, including dematerialization, investor protection norms, move toward
T+2 settlement and CLA (Central Listing Authority), for which the notification would be
issued soon (Business Standard News, 2003).the capital market development in India is
evident from the following table:
36
Table 2.1 NEW CAPITAL (PUBLIC & RIGHTS) ISSUES & INVESTMENT
MADE BY FOREIGN INSTITUTIONAL INVESTORS (FIIs)
Year
New Capital IssuesNet Investment of FIIs
(At monthly exchange rate)
No. Of
Issues
Amount
Raised
(Rs.Mn) Amount
(US $ Mn.)
1992-93 1016 186906 4 1993-94 1143 243720 1634 1994-95 1692 27635 1528 1995-96 1725 208037 2036 1996-97 882 142760 2432 1997-98 111 45700 1649 1998-99 58 55865 -386 1999-00 93 78168 2339 2000-01 151 61078 2160 2001-02 35 75431 1846 2002-03* 22 32859 360
*April-February 2002-03
Source: Securities and Exchange Board of India
The CMDP implemented in Bangladesh spanned over three years, and aimed to
create a policy environment conducive to the orderly growth of the domestic capital
market and help establish the institutional infrastructure necessary to sustain the capital
market’s long-term development. Low savings and investment rates were restricting
economic growth in Bangladesh. Banks could provide only limited funds and capital was
needed from other sources to get the economy moving. Stock market growth was
37
hampered by a weak regulatory framework, ineffective supervision and a lack of
accountability. The Ministry of Finance is the executing agency responsible for creating a
broad-based, competitive, efficient and stable financial system fosters investor
confidence and encourages savings and investment (ADB, 1997).
Pakistan also needs to develop its securities market to enhance resource allocation
and to broaden and deepen the financial sector while at the same time providing
alternative funding sources to industry, which has had to rely on Government-directed
credit. The stock market has been hampered by weak infrastructure and regulatory
restrictions on institutional investors who are required to invest a large proportion of their
funds in Government securities. Key market participants such as mutual funds, insurance
industry and leasing companies are prevented from playing a full role in the capital
market by constraints such as tax anomalies, a predominance of the public sector and
regulatory weaknesses. The CMDP aims at a fairer, more efficient and regulated system
with fewer regulatory and tax constraints. The broad-ranging reforms are expected to
stimulate savings and investment and have a positive impact on economic growth, job
creation and real incomes. Other measures supported by the CMDP include upgrading
automated trading systems to pave the way for an integrated national market. The
program will also develop the corporate debt market and the mutual funds, insurance and
leasing industries, all of which will benefit from the elimination of discriminatory policy,
regulatory and tax regimes (ADB, 1997).
38
The capital market in Pakistan has been undergoing a major restructuring
program. This includes establishment of a Securities Exchange Commission of Pakistan
(SECP), Central Depository Company (CDC), automation of trade at three stock
exchanges and credit rating agencies. A number of measures have been taken to liberalize
investment procedures encourage capital formation through stock exchanges; enlarge
depth and size of the stock markets. Still a lot more has to be done to ensure transparency
and make the market efficient (Kazmi, 2000).
. These days Reforms are the order of the day in most of the developing countries
of Asia because they assist in:
Improving the fiscal, interest rate and investment policy environment, such as
rationalizing taxes for financial instruments and investors, providing incentives to
stimulate long-term savings, and removing distortions in securities investment
criteria and foreign exchange transfer for insurance.
Boosting investor confidence, through increased transparency and better
governance standards, and strengthening of the regulator's enforcement capacity.
Increasing the supply of financial instruments and bolstering market infrastructure
through establishing a separate counter for newly listed and smaller companies,
reform of the stock exchanges, further upgrading of trading, clearing and
settlement systems, introducing a system of market making for debt and equity,
and developing regulations for the issuance of commercial paper and financial
hedging instruments.
39
Developing contractual savings to encourage private sector participation through
institutional investment. This includes improving asset management for pensions
and life insurance, developing a framework for private pensions and encouraging
mutual funds to tap into retail investment.
Improving governance and soundness of operations of non-bank financial
institutions through increased private sector participation, improved risk
management standards and consolidation to fewer but stronger institutions. (ADB,
2002)
Governments have been ineffective in addressing weaknesses of the capital
markets. They tried to do too much, dictating resource allocation of financial institutions
and bailing out inefficient and virtually bankrupt banks, financial institutions and state-
owned enterprises. ADB has proposed a disclosure-based and market-based philosophy
of market regulation. This would transform market participants from reluctant to willing
partners as far as compliance and disclosure of information are concerned. Under this
approach, instead of government regulators imposing value judgments, market
participants would have the incentive to comply for their own protection. Market
regulators would not have to waste limited resources on evaluations because these could
be carried out by market participants through full disclosure. This same approach can
improve corporate governance because too much government is blamed for poor
corporate governance (ADB, 2000).
40
Two issues should be focused upon in terms of improving the environment of the
capital markets. One of them is investor education. A lot that needs to be done in terms of
actually improving the level of awareness of the average investor in terms of what it is
that they are actually getting into, when they invest in the securities market. In fact, in
larger economies too, investors are not very aware of the consequences of their choices.
Enron is a classic example. Their own employees had absolutely no idea what they were
doing when they were buying Enron shares with their retirement money. So, the least that
can be done is to educate the investors. The second is the ability to enforce the laws made
to ensure the efficient working of the capital markets. You may have the best laws in the
world, but an inability to enforce them is potentially a bigger problem than the macro
economic or micro economic reforms. If market participants feel that they can get away
with breaking laws, then the sort of capital market countries are aiming to have, will not
be possible (Healy and Palepo, 2002).
41
RESEARCH METHODOLOGY
3.1 TYPE OF STUDY
The research studies the reforms introduced by ADB for the development of the
capital market in Pakistan. It is a descriptive study since the researcher is describing the
situation that led to the reforms being introduced, their implementation and its effect and
the future of these reforms.
No primary research was carried out and all the data was gathered from secondary
sources, so it is a secondary research.
3.2 RESEARCH DATA
The information for conducting this research study was collected from secondary
sources like magazines like Pakistan & Gulf Economist, Finance and Market Magazine
and monthly Management Accountant; newspapers such as Dawn, The News, The
Nation, Pakistan Times and Business Recorder; research journals like Harvard Business
Review, The Pakistan Development Review and Journal of Asian Economics; news
releases from Agencies like Asian Development Bank and World Bank; Annual Reports
of Securities Exchange Commission of Pakistan, Karachi Stock Exchange and State Bank
of Pakistan and from research papers conducted by staff teams of International Monetary
Fund and World Bank.
42
INTERPRETATION &ANALYSIS OF DATA
4.1 THE PRE- REFORM ERA
In the Pre- Reform Era, the securities market in Pakistan was characterized by the
limited equity of established, reputed and well-managed companies. Almost all financial
institutions in Pakistan were involved in the securities business. Despite the active
participation of institutions such as Nationalized Commercial Banks (NCB), Investment
Corporation of Pakistan (ICP), National Investment Trust (NIT), newly created
investment banks, and Development Finance Institutions (DFIs), the equity market in
Pakistan remained small. Since the corporate sector was relying more on DFIs for their
financing needs, this did not allow equity market to develop significantly. This was a
policy-induced outcome as most of the DFIs were in the public sector and were providing
long-term finance at concessionary rates. Some other reasons for under-development
were:
Cost: Cost of equity was significantly higher than debt as dividends were paid out
of after-tax profits while interest on loans, invariably subsidized, was tax
deductible.
Lack of depth: Non-presence of a large number of buyers and sellers willing to
buy/sell at prices above/below the prevalent levels, led to concentration of
holdings, which resulted in illiquidity and failure of stock prices to reflect the
intrinsic value of the company.
43
Lack of breadth: Pakistan's limited industrial base reduces the choices available.
The herd mentality in establishing industries resulted in over-capacity of different
sectors. The financial sector was affected with high percentage of non-performing
assets and defaults in an environment where borrowers' quality, financial health,
management efficiency and ability to repay was increasingly suspect.
Crowding out effect: Heavy government borrowing to finance successive budget
deficits had severely limited the availability of credit to the private sector for
capital market investments. Even the pension funds, by law, were restricted
primarily to government securities only.
Low equity base of companies: The equity base in Pakistani companies had been
very low ranging between 25% and 30% of the assets. The management of
profitable family owned entities avoided going public and share the benefits with
the general public as well as open its operations to greater transparency that
listing on the stock exchanges requires.
Pricing of equities: Until 1993, the Karachi Stock Exchange did not allow shares
of new companies to be issued at a premium. Even when this was allowed, the
criteria to justify issuance of shares at a premium, failed to prevent unfair
practices.
44
Lack of investor confidence: The degree of informational efficiency at KSE
used to be relatively low and thus insiders played a greater role. The general
investors were deprived of a level playing field.
Financial disclosure by companies: Listing involved obligation to disclose
information, which the companies preferred to avoid. There was an acute dearth
of timely and accurate financial information. The lack of details in the annual
reports considerably reduced the usefulness of the disclosure.
Protection of minority interest: The dividend payouts by listed companies in
Pakistan remained very low, which was a cause of concern for minority
shareholders.
Pakistan’s equity market has been underdeveloped for many years. It was in the
backdrop of heavy speculative trading, negligence in implementing exposures and loss
regulation, irregularities in appointment of directors and mismanagement of funds, late
filing of accounts and non- holding of annual general meeting that a growing need to
discipline the market was felt. Time had come to impose strict risk management
measures, review the existing rules and eliminate unhealthy trading practices and bring
about changes for organized and smooth working of stock markets.
Table 4.1 PERFORMANCE OF KSE IN THE PRE- REFORM ERA(Amount in Billions of Rs)
45
Source: State Bank Annual Report, 2002
In recent years, the government increasingly came to realize the importance of
improving the efficiency of the securities market and its relevance to private sector
development and economic growth. In the context of Pakistan, securities market has a
special significance, as equity instruments are the truest form of riba-free investment
besides achieving socio-economic objective of imparting a sense of participation to the
general public in the prosperity and development of the country.
4.2 OBJECTIVES OF THE CAPITAL MARKET
DEVELOPMENT PROGRAM
The development of a secondary market depends on a variety of factors, including
capability and skills of dealers in market making, privileges provided by the central bank
that allow dealers to carry out their obligations, quality of the payment system in terms of
efficiency and ease, spectrum of alternative government and non-government debt
instruments available to investors, and saving behavior of economic units in the country.
For rapid development of the capital market, Government of Pakistan took a
number of policy decisions, which have gone a long way in revamping the overall
structure of the stock market and seek to create a conducive investment friendly
46
environment. The Government’s top priority at the time of program formulation in early
1997 was to restore political and economic stability in the country. It requested ADB
assistance in capital market reforms to augment and complement such activities. Reforms
of the securities markets, encompassing both primary and secondary markets, were aimed
to improve the prospects for issuers to mobilize long-term resources and provide
alternative opportunities to suit their preferences, to create a higher degree of credibility
and competition in the industry and to minimize business risk.
To achieve these objectives, the regulatory and institutional frameworks were to
be strengthened to improve investor confidence, market distortions eliminated, the
securities market infrastructure modernized and upgraded, investment alternatives
improved, and the efficiency of market participants enhanced.
The Capital Market Development Program initiated by ADB, aimed to augment
the mobilization of long-term resources and improve the efficiency of their allocation
through a diversified and competitive capital market, which encouraged broad-based
participation of issuers and investors. The Program covered seven key areas, in support of
developing the capital market:
Creating a policy environment to enhance competition, and a level playing field
Strengthening governance, institutions, regulations, and supervision of the
securities market
Improving and modernizing securities market infrastructure and its integration
Developing the corporate debt market
47
Introducing reforms in the mutual fund industry
Developing the leasing industry
Promoting contractual savings through reforms of the insurance sector and
pension and provident funds.
Detailed list of reforms is attached in Appendix 1
4.3 CAPITAL MARKET DEVELOPMENTS IN PAKISTAN
The capital market in Pakistan has been witnessing steady progress and
structural developments in both its institutional set-up and operational matters since the
early 1990s. Credible maturity has been achieved in the working of the capital market
despite some adverse domestic and international shocks in the last few years. The
present Government not only continued the market oriented development strategy of
the 1990s but also added some new impetus to improve the working and depth of
capital market in Pakistan. Along with domestic investors, foreigners and overseas
Pakistanis are now also offered every possible incentive and opportunity to undertake
investment in projects of their choice.
The first phase of ongoing reforms in the capital market initiated by the ADB
have been completed. ADB expressed its satisfaction over the implementation of the
first phase of reforms of the capital market and has recently approved an integrated
assistance package of three loans and two political risk guarantee facilities, under the
Financial Markets Governance Program (FMGP) for initiating the second phase of
capital market reforms in Pakistan. 48
The successful completion of the first phase of reforms left a healthy impact on
the working of the capital market, which has now become more efficient, reliable and
transparent. This improvement was noted both within and outside the country. The
second phase of reforms builds on to the earlier improvements, and is largely
developmental in nature. These reforms will have the effect of bringing Pakistani
markets in line with best international practices.
After recording impressive performance in 2001-02 the KSE-100 index resumed
its upward movement in 2003. Pakistan’s stock markets have remained buoyant during
2002- 2003, with the KSE- 100 witnessed a phenomenal growth to an all time magic high
figure of 3900 points in July, 2003 and the market capitalization of the exchange now
stands above $15 billion. This milestone was achieved because of the government’s
macro economic policies, strengthened macro- economic indicators, and the confidence
of both local and foreign investors’ on the country’s economic policy and on the KSE.
Yet another indicator of impressive performance of the Karachi Stock Exchange has been
an extraordinary surge in monthly turnover of shares from 2.4 billion in 2001-02 to 4.0
billion during July-April of 2002-03. The average daily turnover of shares has increased
from 74.3 million in 2001-02 to 104.7 million in the first two quarters of 2002-03 and
further to 243.1 million shares in the third quarter of 2002-03. Bullish business trends are
also being witnessed during the years at the other two stock exchanges namely, the
Lahore and Islamabad Stock Exchanges. The ISE started functioning in August 1992 and
within ten years it has developed into a vibrant, efficient and stable market. Today, the
49
ISE is one of the premiers Stock Exchanges of the country known for the highest
standard for transparency in its operations, excellent risk management, dynamic market
technology and lowest overall costs of listing.
Table 4.2 PROFILE OF THE STOCK EXCHANGES IN PAKISTAN
KARACHI STOCK EXCHANGE
1999-2000
2000-01 2001-02 2002-03 * April 2003.
(July-March)
a) New Companies Listed 1 4 4 1
b) Fund Mobilized (Rs Billion)
8.9 3.6 15.2 23.1
c) Listed Capital (Rs Billion)
236.4 235.7 291.2 299.3*
d) Turnover of Share (Billion No)
48.1 29.2 29.1 36.2
e) Average daily Turnover of Share (in million)
202.1 122.5 158.6 243.4
f) Aggregate Market Capitalisation (Rs Billion)
392 339.2 407.6 637.0*
LAHORE STOCK 1999-2000
2000-01 2001-02 2002-03
EXCHANGE (July-March)
a) New Companies Listed 2 3 3 2
b) Fund Mobilized (Rs Billion)
0.4 2.5 14.2 1.7
c) Listed Capital (Rs Billion)
207.7 226.2 246.3 282.7
d) Turnover of Share (Billion Nos)
16.4 7.8 18.3 19.5
e) LSE Index 372.0 273.5 297.5 496.6
50
f) Market capitalization (Rs Billion)
365.9 325.7 393.3 595.8
ISLAMABAD STOCK
1999-2000
2000-01 2001-02 2002-03
EXCHANGE (July-March)
a) New Companies Listed 0 5 1 0
b) Fund Mobilized (Rs billion)
0 0.8 3.7 0
c) Listed Capital (Rs billion)
- 183.3 183.4 228.2
d) Turnover of Share (In Billion Nos)
3.1 1.4 1.70 1.3
e) ISE Index 5327.2 4374.2 4684.0 5924.5
All the 12 major trading groups on the KSE (cotton and other textiles,
pharmaceuticals & chemicals, engineering, auto & allied, cables and electric goods,
sugar and allied, paper and board, cement, fuel and energy, transport and
communication, banks and other financial institutions, and miscellaneous) recorded
positive growth in their share indices, ranging from 1.7 percent (cement) to 79.8
percent (auto & allied).
This performance, which appears to be underpinned by a steady improvement in
economic fundamentals during the course the year, is more impressive when viewed the
context of the various economic and non economic shocks suffered by the country, as
well as a number of disruptive market developments.
Table 4.3 KEY INDICATORS OF CAPITAL MARKET
51
Source: State Bank Annual Report, 2002
Pakistan has now a capital market with high degree of integrity and transparency in
terms of price discovery and trade settlement. The observance of enhanced accounting
standards, reliable audits, institutional strengthening and capacity building of the
Securities & Exchange Commission of Pakistan (SECP) have been the hallmark of the
capital market reform program. Pakistan is today largely compliant with International
Organization of Securities Commission’s (IOSCO) 30 principles of securities
regulation. The market friendly measures introduced during the last four and a half
years had a significant impact on investor confidence and the stock market is no longer
viewed as attracting only die- hard speculators. The structural changes brought about
by the government have been quite successful in restoring investors’ confidence in the
equity market. The market has clearly attracted genuine investment as is evident from
the fact that actual settlement has risen from about 1 to 2 percent of trades in the early
part of year 2000 to around 10 to 15 percent by June 2003. Although equity issues have 52
not picked up, there has been a significant increase in debt capital issues, the aggregate
amount of new capital listed in the last two years being as much as Rs 30 billion etc.
Figure 4.1 GROWTH IN THE TFC MARKET
In Pakistan, the Karachi stock exchange is playing a central and critical role in
shaping the savings and investment climate, as it is the main window to ensure that the
market continues to grow and generate interest of investors both within the country and
abroad.
53
Till the fifth year of implementation of reforms i.e. 2003, many developmental
steps have been taken regarding various aspects of the capital markets to ensure
compliance with the ADB’s proposed reforms and to enhance market efficiency and
investor confidence. The important initiatives in this regard are highlighted below.
4.3.1 Privatization Of State -Owned Enterprises:
Privatization has again been revived, with emphasis on phasing the process
through domestic listing of public sector entities on the local stock exchanges initially.
This is to be followed by induction of professional management and only then inviting
strategic investors at the international level.
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The government of Pakistan is firmly committed to privatization because it
expects to enhance the quality of goods and services, strengthen the fiscal position,
broaden and deepen the capital markets and reduce opportunities for corruption.
The government is working to improve liquidity. Under the new privatization
strategy, it's selling off its shares of state-controlled companies while listing them on
the bourse as well. This government policy to sell its share in large State-Owned
Enterprises (SOEs) through stock exchanges was of great significance in development
of the equity market. Increased supply of securities such as the Pakistan
Telecommunication Corporation (PTC) and the Muslim Commercial Bank (MCB), and
the large issue of a power project, namely the Hub Power Company (HUBCO), which
has been actively traded, have considerably increased the market depth. In last four
months, about $70 million worth of stock in three state-owned companies has been
sold, and more is expected to follow. For instance, two state-owned energy companies,
Pakistan Petroleum Limited, and Pakistan Oil & Gas Development Corp. are expected
to be listed by the end of 2003.
4.3.2 Securities Exchange Commission Of Pakistan:
In the past, the Corporate Law Authority (CLA), which was a subordinate
department of the Ministry of Finance (MOF), was responsible for the regulation of the
capital markets. The policies of liberalization implemented in the l990's led to rapid
expansion in Pakistan's Capital Markets which called for a more professional approach
for regulation. On the supervisory front, CLA’s control over capital market was
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compromised due to lack of autonomy and overlapping of some functions with Monopoly
Control Authority and Controller of Capital Issue. In addition, inadequate professional
capacity restricted these agencies to exercise their supervisory functions effectively. On
the other side, stock exchanges lacked proper infrastructure for trading and settlement. A
well-equipped regulator conforming to international standard with adequate capacity to
monitor the market was needed and this need for regulation was also expressed by the
ADB.
This long over-due process started in January 1999 when an autonomous
Securities and Exchange Commission was set up to replace the Corporate Law Authority
(CLA), which could not possibly meet the new challenges arising out of the dynamic
market development. The Commission became financially autonomous in July 1999 - six
months after its establishment. SECP was established as the chief regulator of the stock
exchanges and was entrusted with the task of initiating reforms to improve the working of
the stock exchanges. The SECP’s role was further enhanced when it was assigned
regulatory responsibility for the insurance industry, and private pension schemes and
other non-bank financial institutions (NBFIs) i.e. leasing, housing, and investment banks
in 1999 and 2000 respectively.
4.3.2.1 Functions: The main functions of the Securities and Exchange Commission of
Pakistan according to the SECP Act are:
Maintain facilities and improve performance of companies and securities markets.
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Maintain the confidence of investors in securities markets by ensuring adequate
protection.
Achieve uniformity in performance of functions and exercise of powers.
Administer laws effectively with minimum procedural requirements.
Receive, process and store, efficiently and quickly, the documents lodged with
and information filed with.
Ensure that documents and information filed with the commission are accessible
to the public.
4.3.2.2 Superiority over CLA: The main advantages of the Securities and Exchange
Commission of Pakistan over the Corporate Law Authority are:
As compared to the CLA that needed the approval of the Ministry of Finance
before taking action, the Securities Exchange Commission of Pakistan is an
announced body.
The commission has been granted the power to take action on its own initiative
without having to wait for a complaint to be filed.
The conclusion of three representatives of the public (2 chartered accountants and
an investment banker), in the 5 commissioners of the Securities and Exchange
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Commission of Pakistan has greatly increased transparency and seek to ensure
greater protection of the rights of general investors.
Thus, the regulation and governance of Pakistan's financial market and corporate
sector has been substantially strengthened with the commencement of operations of the
SECP in 1999. The initiatives taken by the SECP are aimed towards ensuring that the
exchanges conduct themselves as a national institution, fully protecting the interest of
investors, who are the major stakeholders in the system. Over time, the Commission, as a
regulator, has been entirely transformed through the implementation of a drastic
restructuring program that was largely completed during 2001-2002. The institutional
capacity was strengthened through appropriate reorganization, staffing, training and
automation. The Commission now has reasonably well-functioning units that keep the
market under surveillance, enforce the law it administers, closely monitor and try to
foster the various specialized institutions it regulates, and keep vigil to ensure that the
various activities under the ambit of the Commission are performed effectively and
efficiently. While there is considerable ground that is yet to be covered, it is felt that in
many respects the Commission is approaching International standards in the discharge of
its regulatory responsibilities.
4.3.2.3 Monitoring & Surveillance: Since it became operational, SECP has
implemented many laws for the betterment of capital market. Although stock exchanges
in Pakistan are mostly self-regulating authorities, SECP is actively monitoring their
activities and making amendments in regulations to create a level playing field for all
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investors. The SECP has set up a Monitoring and Surveillance Wing. The Surveillance
Wing carries out on line monitoring of the stock exchange to effectively monitor the
activities at the exchange and to take corrective measures as and when needed.
4.3.2.4 Enforcement Division: The SECP has already created an Enforcement Division
under a full-fledged Commissioner who is monitoring the performance of listed
companies. The SECP has a plan to strengthen its investigative unit by induction of
properly qualified and trained staff for such purpose
A solid foundation has been laid by the Commission to ensure healthy growth
of the capital market. It is continuously engaged in efforts to strengthen the integrity
and efficiency of the capital market so that the investors develop a sense of confidence
in its operation.
4.3.3 Central Depository Company (CDC):
Another noteworthy step in the reform process was the creation of the Central
Depository Company of Pakistan Limited (CDC) in 1993 to facilitate electronic transfer
of stocks. The CDC commenced its operations in September 1997. This depository
company was established by stock exchanges in collaboration with the International
Finance Corporation (IFC), Citibank, leading commercial banks and DFIs. This greatly
encouraged market activity and streamlined the settlement process. The central
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depository was one of the most vocal demands of foreign investors and with its setup
there has been a manifold increase in trading on the exchange.
The affect of CDC on the workings of equities market is tremendous. In fact,
CDC has revolutionized the settlement procedures of stock exchanges completely. It has
not only reduced the cost of processing transactions for investors as well as Central
Depository System (CDS) elements, it has also brought extraordinary efficiency and
transparency in security transactions which was desperately required to restore the
investors (both local and foreign) confidence. This change has brought the Pakistani
market at par with rest of the world.
4.3.3.1 Services provided by CDC: CDC provides the following facilities:
Eliminating paper settlement along with the problems associated with it
like fake/stolen/lost share certificates etc.
Settlement through CDS is electronic; the transfer of ownership is
instantaneous (which previously used to take 45 days).
It does not attract stamp duty reducing the cost of investors.
Delivery versus Payment Facility (DVP): DVP is the international
settlement standard which involves the simultaneous and irrevocable exchange of
cash and securities. A safe and efficient settlement system, which is a bilateral
transaction between two Account Holders/Participants in which funds and
securities are transferred from one account to another electronically. Previously,
there used to be a small timing difference between release of securities and
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payment, which increased default risk by either party. DVP reduces the settlement
risk through simultaneous exchange of securities and funds. In DVP, the CDC
maintains a central cash and securities' account for all participants and undertakes
a trade only when sufficient balance exists in both parties' accounts. Since DVP is
the international standard, this has given a tremendous boost to the foreign
investors and further improved their confidence in the local market.
Investor Account Services: Allows investors to directly open and maintain
accounts in Central Depository System for electronic settlement of securities.
Earlier, to settle the securities through Central Depository System, investors had
to open client accounts (sub accounts) or group accounts with the Participants
(brokers; financial institutions). Now, with Investor Account Services, investors
can also have direct access to CDC.
CDC is not a profit maximizing organization. Its focus is more on helping the
equities market to become more efficient and transparent then to generate revenues and
its track record is a witness to its claim. CDC has reduced its charges significantly since
becoming operational and it will continue to do so in future as well. Its aim is to generate
enough revenue to keep running and to keep some for future growth. As and if it makes
more, it will reduce its charges.
CDC is also considering asking the State Bank of Pakistan (SBP) to give approval
to make government securities scripless and have all of them listed in its system. The
SBP has given the CDC permission to start work on this project - the anticipated time
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being around 12-18 months. While trading would be delegated to the CDC, overall
control of these government securities will remain with the SBP. Such a move will not
only help automate the government paper dealing, it will also provide a central forum for
trades in all kinds of money market and capital instruments.
For further improvement of market infrastructure and ensure efficient trading, all
listed companies are being motivated to enter the central depository system. CDC is now
an integral part of the stock market in Pakistan and has completed five and a half years of
its operations.
In the past, the KSE had been relatively looked down upon in the regional
markets due to its technological and operational backwardness. However, with these
recent developments, this perception has changed. In fact, the capital market reforms of
the ADB have already gone a long way towards introducing professionalism and
innovation in the market. Most of these reforms are heavily IT based and follow on the
patterns of the more developed exchanges.
4.3.4 Opening Of Capital Market To Foreigners:
Exchange reforms proved to be of great significance in the development of capital
market. Through these reforms, foreigners and oversees Pakistanis were allowed to make
investments without prior approval except in few specified industries. This resulted in
large inflows of foreign funds. Furthermore, the permission to retain 100 percent equity
by foreign investors in a company with no obligation to go public helped improve their
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confidence in Pakistani markets. Other important steps in this regard were: the
permission to bring in any amount of foreign currency and to take it out freely; treatment
of foreign private investment with regard to taxes on income, at par with those applicable
to similar investment made by citizens of Pakistan; and relief from double taxation in
cases of those countries with which Pakistan had treaties for avoidance of double taxation
4.3.5 Automated Trading:
During the 1990s, in the pre- reform era, trading was carried out through open
outcry system. Due to lack of automation, turnover remained very low, and in the
absence of a depository company, investors had to take physical delivery of shares. The
SECP has designed a system for Internet trading along with a regulatory framework. All
three stock exchanges moved to fully computerized trading by mid-1998. In the KSE, it is
known as KATS (Karachi Automated Trading Screen), which has completely abolished
the open outcry system. Necessary amendments in the existing software at the three stock
exchanges regarding automated trading have been made. The automated trading system
has also made transactions transparent and easier to execute.
4.3.6 Risk Management Measures:
After the crisis of May 2000, SECP took up the question of strengthening risk
management with the management of all three stock exchanges.
4.3.6.1 Regulations for short selling: Short selling has been prohibited by the SECP and
it has also been restrained from inter-settlement carry over. All outstanding trades are
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required to be settled and no carry over is allowed unless the possession of shares is
evidenced. This action would prevent volatility in price fluctuation; and stabilize the
market. This restriction was extended to all listed companies on December 4, 2000.
In an effort to regulate short selling in the ready market and to bring it in line with
international best practice, the Commission approved the Regulations for Short Selling
under Ready Market, 2002 in February 2002. Introduction of these Regulations is a
significant step towards minimizing market manipulation and ensuring a healthier and
more transparent capital market
4.3.6.2 Transparency in broker dealings: Additional rules governing the broker's code
of conduct and disciplinary actions have been introduced and all brokers are required to
adhere to them. This ensures an adequate level of transparency in broker actions or
dealings as well. It would be worth mentioning that this rule will be quite useful for small
investors have can easily be taken for a ride. A recent case of broker pledging securities
of his underlying investor (who subsequently lost them when the broker defaulted) can
easily be prevented by this rule.
4.3.6.3 Undisclosed Trading System: Another important development in the stock
market is the implementation of “Undisclosed Trading System”. On October 7, 2002, the
KSE launched this trading system where the identity of the buyers and sellers is not
disclosed. This is in accordance with international practice and has helped check
manipulation and front running to a certain extent.
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4.3.6.4 The Investor Protection Fund (IPF) And Clearing House Protection Fund
(CHPF): The Investor Protection Fund (IPF) and Clearing House Protection Fund
(CHPF) have been set up to ensure effective risk management in the secondary market
and to protect investors’ interest in case of default by members of the exchanges. The
Commission observed that the funds were not fully funded by the exchanges and directed
them to ensure that the IPF and CHPF become fully funded by June 30, 2007. The
requirement has been phased-in so that by June 30, 2002, the exchanges would have to
fund at least 50 percent of the actual contributions made towards IPF and CHPF.
Thereafter, the funding requirements would increase gradually so that by June 30, 2007,
both funds would be fully funded.
Furthermore, the Commission has also directed that an auditor found guilty of
professional misconduct would not be allowed to audit the accounts of listed companies
for a period up to three years. It is expected that these measures would go some way to
protect the interests of the investors.
4.3.7 Carry-Over Trade (COT) System:
In September 2001 and May 2002, the market witnessed abnormal price
fluctuations due to the September 11 events and growing cross-border tension between
India and Pakistan, respectively. On both occasions, the risk management measures,
earlier introduced by the Commission, worked effectively. However, certain weaknesses
were observed in the COT system. The volatility of the market also exposed certain
shortcomings in the Carry-over Trade system (COT), which prompted both, over trading
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by weak holders as well as sudden withdrawal of funds by COT financiers. These
weaknesses were discussed at length with various stakeholders including brokers,
investors and stock exchanges’ management and also deliberated in meetings of the Stock
Exchanges Coordination Committee and the Consultative Group for the Capital Market.
To ameliorate the situation, the Commission introduced several remedial measures in
2002 that helped in strengthening regulation of the COT market and the stock exchanges
were advised to make the following changes in the COT system:
COT should be for a minimum period of 10 days with the financee having the
option to release it after one day
COT should only be allowed in specified liquid shares
Higher margins should be mandated for COT
COT shares should be kept with the CDC or with the clearinghouse of the stock
exchange and should be pledged in the name of the financier, if the financier were
a bank or a financial institution.
The carry-over market movement closely paralleled that of the ready market.
Between September 2001 and June 2002, the daily traded value in COT averaged Rs.
3.5 billion with a low of Rs. 0.03 billion on July 13, 2001 and a high of Rs. 11.5 billion
on February 8, 2002.
Figure 4.3 TRADED VALUE IN READY & CARRY-OVER MARKET (JULY2001-JUNE 2002)
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Source: SECP Annual Report, 2002
4.3.8 Regulation Of Brokers:
In order to bring transparency in the business of stock market, brokerage houses
and members (broker/dealer) a proper system of inspection of books and records of such
brokerage houses/brokers is being established. The regulation framed comprehensively,
lists out documents/records, which the brokerage house/brokers would be obligated to
present for inspection to a person authorized by the Commission for the said purpose.
The basic aim of these regulations is to ensure fair dealing, proper documentation etc.
Failure to comply with the regulations would entail penal action.
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The Commission promulgated the Brokers and Agents Registration Rules in May
2001 to establish a direct regulatory nexus with brokers and agents for protection of
investors’ interest. No person can act as a broker or agent to deal with transactions in the
securities market, unless registered with the Commission. The registration of brokers and
agents under the Brokers and Agents Registration Rules 2001 started on November 1,
2001. These regulations enable direct controlling of brokerage activities. It allows smooth
operation of stock market and serves as a tool for investor protection. The statistics with
respect to registrations granted up to June 30, 2002 are presented in the table below.
Table 4.5 REGISTRATION OF BROKERS &AGENTS
Source: ADB Report, 2002
Registration of brokers and agents has had a positive impact on stock market
dealings owing to the enhanced level of awareness created amongst brokers and agents
regarding the level of integrity and care required of them in the conduct of their business.
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4.3.9 T+3 Settlement System:
In order to reduce systematic risk in the stock market, the “Group of 30”
recommendation called for the utilization of rolling settlement on a minimum of T+3
basis (trading date plus three days). In T+3 settlement system, the purchase and sale
transaction must be delivered and settled on the third day following the date of trade.
In the past, the stock exchanges in Pakistan had been following fixed trading
settlement system. The trading was carried out for fixed period normally from Friday to
Friday to be settled the following Wednesday. The Exchanges clearing house thus carried
the settlement risk for about ten days. At times the period was even longer than ten days
due to holidays or some other reason. It was particularly high in case of our stock
exchanges, which were relatively illiquid and could be manipulated easily. In the past,
many defaults by members occurred due to over exposure of members on account of this
longer clearing cycle. The weekly settlement system, together with Badla and open
window led to huge turnover and mindless speculation. Due to this it became a market
where people could buy shares with no money and sell without possessing any shares.
The T+3 system is aimed at capping systematic risk and improves efficiency of
the settlement process. It has been introduced in order to bring down speculative and
overtrading beyond the financial capacity of the brokers thereby risking the investors’
hard earned money.
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4.3.9.1 Benefits: Implementation of T+3 is a significant achievement, which has gone a
long way in improving the markets’ efficiency and transparency. The main benefits of
T+3 system are:
It reduces risk as the time between execution of trade and settlement of trade is
cut down substantially.
It helps generate liquidity as the buyer will receive the shares and the seller will
receive the cash earlier i.e. on the third day of trade whereas presently both buyer
and seller will receive shares or cash whatever the case maybe, on the 10th day.
It particularly provides comfort to foreign institutional investors as T+3 settlement
system is internationally known and is in line with other major stock exchanges of
the world.
Under T+3 with CNS facility, all settlement is made with the clearinghouse rather
than with a contra-clearing member. The T+3 system with CNS eliminates the possibility
of multiple deliveries or receipts on a settlement day. It also permits an additional level of
vetting by eliminating the need to actually settle a given day’s transactions on settlement
day and carrying the position over to net with the settling trades on the next settlement
day. This facility enables the broker to reduce the actual settlement movements thereby
reducing the costs.
The implementation of T+3 first resulted in reduced turnovers at the stock
exchanges and people misinterpreted it with faults in the system itself and its inability to
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complement Pakistan’s equity market structure. However, the low turnovers were due to
the lack of understanding, lack of practice, natural resistance to unknown and parallel
availability of the old system. There were some minor dislocation in the trading system,
but it is now back to be normal since the investors have fully realized its benefits.
The implementation of the T+3 system with CNS has gone a long way in bringing
the capital market in Pakistan in line with international standards and has greatly helped
in restoring invertors’ confidence particularly of foreign investors who feel more
comfortable with international standards.
4.3.10 Capital Adequacy Requirement:
The SECP has implemented capital adequacy for stockbrokers. Previously, the
KSE allowed brokers to carry an exposure of Rs 50 million free of cost. The SECP has
come out quite vocally against this and now there is no deposit-free exposure limit and
exposure up to Rs 50 million will require a 5 per cent deposit. These deposits are
accepted in either cash or securities, as is the current practice.
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The member would be required to maintain a capital adequacy ratio, which is 25
times of the net working capital. All exposure of the brokers is now subject to margin.
Members would now be required to deposit five percent margin against their trade within
the exposure limits The net capital balance requirement has been substantially increased
to 2.5 million rupees in case of a stock exchange having a turnover of securities
exchanging 15 billion shares; Rs 1.5 million in case of turnover of securities exceeding
7.5 billion; and Rs 0.75 million in case of turnover of securities not exceeding 7.5 billion.
4.3.11 Insider Trading:
The regulations imposed by SECP aim at curbing trading on the basis of
privileged information. The act of dealing in securities of listed companies on the basis of
unpublished price sensitive information or communicate any unpublished price sensitive
information to any person has been made a culpable offense, carrying fine which may
extend to three times the gain accrued or imprisonment for a term which may extend to
three years. They go a long way in curbing the curse of insider trading.
The Securities and Exchange Commission of Pakistan (SECP) has notified the
detailed guideline to be followed by all the stakeholders to check and eliminate insider
trading from the stock markets of Pakistan. The commission reserved the right to proceed
against those who are found violating these guidelines and involved in any manner in this
unethical practice. The detailed instructions titled as “listed companies (prohibition of
inside trading) guidelines” have been effective. Insider trading has been banned under the
Securities and Exchange Ordinance 1969 and the SECP is empowered under the 1997 act
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to frame rules and guidelines to enforce this proposed ban. As per guideline an insider
means:
A person who is director, chief executive, managing agent, chief
accountant, secretary or auditor of a listed company or the beneficial owner
holding directly or indirectly not less than 10% of the shares of a listed company;
or
A person who is or was connected with the company or is deemed to have
connected with the company, and who is reasonably expected to have access, by
virtue of such connection, to unpublished price sensitive information in respect of
securities who has received or has had access to such unpublished price sensitive
information.
The guideline provides that no person who is or has been, at any time during the
preceding 3 months associated with a listed company shall:
Either on his behalf or on behalf of any other person, deal in securities of a
company listed on a stock exchange on the basis of any unpublished price
sensitive information; or
Communicate any unpublished price sensitive information to any person, with or
without his request for such information, except as required in the ordinary course
of business or under any law; or
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Counsel or procure any other person to deal in securities of any companies on the
basis of unpublished price sensitive information.
“Unpublished price sensitive information” in relation to a listed security, as
described in the guideline, means any information which relates to the following matters
or is of concern, directly or indirectly known to a company and is generally known or
published by such company for general information, but which if published or known, is
likely to materially effect the price, of securities of that company in the market;
Financial results (both quarterly and annual) of the company.
Intended declaration of dividends (both interim and final).
Issue of shares by way of right, bonus, etc.
Any major expansion plans or execution of new projects.
Amalgamation, mergers, or takeovers.
Disposal of the whole or substantially the whole of the undertaking.
Such other information that may affect the earnings of the company.
Any changes in policies, plans or operations of the company.
According to the SECP guidelines, the penalty for violation of provisions relating
to the inside trading for a person who deals in securities or communicate any information
or counsel any person dealing in securities in contravention of provisions of previous
section shall be guilty of insider trading and shall be liable to penal action under section
15B of the Ordinance. The commission is empowered, to a point, an inquiry officer to
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investigate and inspect the books of accounts and other relevant record of an insider. The
purpose of the commission is undertaking this exercise.
To protect small investors from excessive volatility in share prices on the basis of
trading driven by privileged information, this law has long been in the offing. It has
helped dispel the insider-outsider perception that deterred small investors from
approaching the capital markets. If this is effectively implemented, this law should be
able to extend the short-term investment horizon that currently dominates the stock
markets.
4.3.12 Buy Back Shares:
The Companies (Buyback of shares) Rule (1999) is primarily motivated to inject
liquidity into those scrips that are not actively traded. Since many of these companies are
largely family owned (and controlled), public offerings, when these companies were first
floated, were done on compulsion rather than a strategic decision to diversify the capital
base of the company. Hence, since these token scrips were first issued to the public,
trading was minimal. It has long been discussed that such companies should have the
right to buy back these scrips to inject liquidity into the market and to encourage more
accurate market valuation. The decision to permit buy back has been allowed on the
condition that SECP will carefully monitor such activity to ensure that companies cannot
manipulate share prices.
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The company law amended in response to a move by the KSE to compel the
management of such listed companies as had been defaulting on dividend payments to
their common shareholders to more than for more than 5 years. The move produced some
good results in that most of the companies started payment of dividends but those, which
were unable to do, so alternatively offered to buy back their shares from common
shareholders intending to sell their holdings. In that case, however the KSE in
consultation with the SECP would fix a buy back price.
By buying back shares when they are being quoted below break-up value,
companies can improve the market price of their shares. Although companies buying
back their own shares will be allowed to cancel them, resale of Treasury Stock will not be
allowed. In order to avail this facility, companies have to maintain a debt equity ratio of
40:60 and a current ratio of 1:1. In addition, other conditions for a buy back include the
passing of a special resolution, a tender and availability of funds from profits available
for appropriation.
The SECP’s decision to make relaxations in the buy back conditions, was seen as
a device to generate buying interest particularly at the juncture when the stock market in
the country was desperately looking for buying support so that the downward movement
in the equity vales could be halted and stability restored. The interesting aspect is that the
latest step provides for a blanket buy back permission for all the registered companies,
irrespective of their trade records in respect of payments of dividends regularly. This
implies that sponsoring groups of leading companies would now have the scope to
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increase their holdings in their own companies to any extent contrary to the original
provision in Company law making it obligatory upon sponsors to offer a minimum of
50% of their paid-up capital for subscription to general investing public and financial
institutions, and then alone their companies would be entitled to be defined as broad
based public limited companies in order to get the benefits of corporate tax at lower than
the rate applicable in the case of private limited companies.
The rules require certification by the auditors as regards the maintenance of
financial ratios at prescribed level, maintenance of the debt equity ratio at an ideal level
of 60:40 and also about the availability of sufficient cash resources. Obtaining of such
certificates not only causes extra financial burden on the companies but also is not
convenient to them, therefore the desired results have so far not been realized.
4.3.13 Declaration Of Dividends:
A part of the Capital Market reforms is that companies are required to pay
dividend at least once every five years. If they do not do so, strict action will be taken
against them. After the reforms process was set in, there was a marked increase in the
number of companies declaring and paying dividend. Regular inflow of dividend
declarations has made a positive impact on the market. The companies declaring
dividends in the three stock exchanges in Pakistan have been increasing each
successive year.
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Table 4.6 COMPANIES PAYING DIVIDENDS AT KSE
Source: State Bank Report, 2002
4.3.14 Over-The-Counter (OTC) Market:
Among a variety of developmental measures taken by the SECP, approval was
granted for establishing, under the aegis of the KSE, the framework of an over-the-
counter, quote driven market targeting closely held or smaller capitalized companies as
well as debt securities. This would appropriately tier the stock market with trading
modalities determined to suit each other.
A quote-driven OTC market, essentially for small-cap stocks and debt
securities, provides investors with an alternative, convenient and efficient avenue to
make investments. Moreover, promoters can set up new projects or expand their
operating activities by raising finance in a cost-effective manner in the OTC market
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where regulatory requirements are less stringent than in case of regular listing. An OTC
market provides several benefits to investors and issuers that include the following:
It provides liquidity to illiquid shares.
It is cost effective for issuers.
It affords opportunities to young companies, without a proven track record, to
raise risk capital for making productive investment.
It enables access to a wide spectrum of financial intermediaries.
It provides venture capital and private equity funds an exit route for their
investments.
The proposed minimum capital requirement for a company to be listed on the
OTC market is Rs. 10 million as compared to Rs. 50 million for the regular market. The
minimum public offering will be Rs. 5 million or 25 percent of the capital whichever is
higher. In May 2002, the Commission approved, in principle, the concept of an OTC
market and the stock exchanges are currently in the process of drafting the necessary
regulations.
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4.3.15 Disclosure Requirements:
The Commission has directed all the listed companies to submit their quarterly
account in an effort to improve transparency and disclosure by companies. The
companies are required to submit these accounts to their registrars and shareholders as
well as to the Stock Exchange and the Commission. Maximum disclosure has been
ensured in the prospectus for information of prospective investors. The review of
prospectus for further improving the quality of disclosure in the prospectus has been
initiated. Further disclosure requirements would be prescribed on the basis of
recommendations of the consultants under CMDPL.
The KSE has also proposed laws seeking disclosure of a party wishing to acquire
substantial holding in a company (which would eliminate insider trading). This is quite a
notable step by the KSE. Other laws include a corporate takeover law (to wipe off the bad
blood in the market) and enhancement of shareholder powers to remove the management.
4.3.16 Accounting Standards:
The SECP has notified and prescribed cost accounting records for companies to
facilitate audit process. Consultative process with trade and professional bodies has been
initiated in respect of quarterly reports to be published by the listed companies. Two new
International Accounting Standards have been adopted. The observance of International
Accounting Standards (IAS) was enhanced further by the end of 2002, when a total of 38
out of 41 IASs were adopted.
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4.3.17 Employee Stock Options:
The Employee Stock option Program (ESOP) has been successfully used by the
developed countries to augment productivity/efficiency by motivating their employees
through this scheme. Under this scheme the shares are gradually allotted which keep on
increasing over a period of time, binding the employees to their companies/corporations
with the sense of sharing ownership. In Pakistan this scheme was initially introduced in
1992 and now comprehensive regulations have been framed, which are being introduced.
New sets of rules were announced in January 2001, to ensure smooth operations of
Employees Stock Options through which it would be ensured that employees are
motivated to have greater share in the companies stock.
4.3.18 Corporate Debt Market:
There has been a significant expansion in the corporate debt market since 1998
partly due to policy changes in the National Saving Schemes (rationalizing rates and
restricting incremental institutional investment) and the launch of the Pakistan
Investment Bonds. In addition, the bearish trend in equity markets during 2001 shifted
investors toward more secure investments in term finance certificates (TFCs). As
against four TFC issues floated in the market before 1998 for PRs 732.37 million
($11.8 million), there were 25 TFC issues mobilizing PRs13, 501 million ($217.8
million) between 1998 and 2001.
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The increasing number of TFC issues shows the interest of the investors in debt
instruments as compared to equity issues. TFCs are gaining popularity among investors
due to a number of factors:
Attractive and guaranteed return and safety of principal amount invested.
Substantial fall in returns under various National Saving Schemes.
Restrictions imposed on institutional investors for investing in NSS.
Figure 4.4 AMOUNT RAISED THROUGH TFCs (1995-2002)
Source: SECP Annual Report, 2002
The SECP has streamlined the procedure for issuance of TFCs by reducing cost
and simplifying procedure of approval, Stock exchange listing fee, brokerage commission
and bankers fee to the issue commission has been reduced. Self-registration has been
allowed. TFCs can be issued in tranche. Publication of abridged prospectus has been
allowed; and Trustee’s responsibilities have been more clearly defined.
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Some TFCs are listed on the exchanges but trading is limited due to lack of
market makers, professional institutional investors, and an opaque trade-reporting system,
hindering price discovery. Additional policy measures, including consideration for
creating a risk-free yield curve by issuing longer-term government bonds and establishing
an over-the-counter (OTC) market for trading corporate debt papers, would be helpful for
the sound development of the debt market and increased trading of fixed-income
securities on the secondary market. The future outlook is quite bullish as companies that
previously relied heavily on development finance institutions for term borrowings are
now accessing the bond market to meet their financial requirements
4.3.19 Future Trade:
Future trade provides an opportunity to separate speculative trades from spot or
real time contracts. It is practiced all over the world and, for a long time, Karachi Stock
Exchange (KSE) had a counter for a forward trade in the selected scrip. Later, this was
discontinued for a certain reasons and was restarted in July 2001, at the request of KSE.
Future trading in simple words is buying and selling of commodities in future on
the basis of standardized contracts. This standardized trading generates massive
transactions provides necessary tools for hedging against potential pricing volatility. It is
transaction of buying or selling of an asset now, but having it delivered at a future date. A
significant factor of such a transaction is that since the delivery is deferred, the asset may
be transacted by paying small amount of money (around 5 to 10 percent of the value of
asset) to gain control over the asset. Internationally, futures are common in stocks, stock
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indices, commodities, currencies, and financial instruments. Derivative products give
depth to the capital market, providing investors with basic hedging instruments and
investment alternatives. Since an asset can be bought or sold by putting forward a smaller
amount of money, these transactions are termed to be highly “leveraged” or “geared”.
Currently, 13 scrips are being traded at both the KSE and the LSE. Stocks are
selected for futures trading primarily on the basis of their liquidity. The 13 selected
companies are Dewan Salman, Ibrahim Fibers, Hub Power Company (HUBCO), Pakistan
State Oil (PSO), Muslim Commercial Bank (MCB), Sui Northern Gas Pipelines (SNGP),
Pakistan Telecommunication Corporation Ltd (PTCL), Nishat Mills, Imperial Chemical
Company (ICI), Engro, Fauji Fertilizers and Fauji Jordan.
In order to regulate futures trading in provisionally listed securities, i.e.
securities that have applied for listing but have not yet been listed, it was considered
essential to frame new regulations. Consequently, in February 2002, the Commission
approved the Regulations for Futures Trading in Provisionally Listed Companies, 2002
for the KSE. Regulations for futures contracts have been approved for the Islamabad
Stock Exchange (ISE) as well and trading is expected to commence shortly. The
Commission is currently working closely with the stock exchanges for development of
a wider range of derivative products, such as options, index futures, swaps, etc.
Futures trade has helped boost the volume and sentiment in the stock market. The
SECP has already issued rules for future trading and they are closely monitoring this
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trade to avoid potential risk in the market. The newly formed futures contracts market has
registered substantial growth. The average daily turnover in futures increased from less
than Rs. 0.5 billion in September 2001 to more than Rs. 1 billion in June 2002. Average
traded value of futures, as a percentage of traded value in the ready market, also
increased from about 30 percent to 45 percent during the same period.
Figure 4.5 FUTURES MARKET (SEPTEMBER 2001- JUNE 2002)
Source: SECP Annual Report, 2002
4.3.20 Corporate Governance:
“It has been universally proved that economies with more transparent corporate
sector attract much more higher degree of private investment as compared to ones that
do not manage higher level of governance” Khalid Mirza, 2001.
In 2001, SECP was eventually able to finalize and implement a Code of Corporate
Governance by making it part of the listing regulations, which consequently became 86
applicable to all listed companies, banking companies, Development Finance
Corporations (DFIs), Non-Banking Financial Institutions (NBFIs), insurance companies,
mutual funds, unit trusts, and companies/ corporations held or controlled by the
Government. Essentially based on the Organization for Economic Cooperation and
Development’s (OECD) principles of corporate governance, the Code acquired its
present shape after extensive consultations with the business community. The Asian
Development Bank has provided Pakistan with a US$750,000 technical assistance grant
to build institutional capacity for adopting better corporate governance standards in the
capital market. This is the second phase of the capital market reforms initiated by ADB
that extends to December 2005. The assistance aims to:
Improve the efficiency of the capital market based on solid governance standards
by undertaking a comprehensive review of the current system and recommending
strategic changes.
Enhance stakeholders' understanding of the dynamics of corporate governance
through exposure to international best practices and knowledge sharing.
Strengthen the capacity of the regulator to promote good corporate governance in
the capital market.
Achieve transparency, institution building, incentives and accountability in the
corporate sector.
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4.3.20.1 Key Features: The key features of the Code of Corporate Governance include:
Separation of management of public owned companies with ownership
Enhanced disclosure and transparency in operations: Publishing of quarterly
financial statements
Quality control of audits: Facilitate quality control reviews of auditors by
permitting the release of audit working papers for this purpose.
Effective representation of minority shareholders and non-executive directors of
companies
40% independent directors on the board of stock exchanges
Four non-member directors to be nominated and appointed by the Commission
Managing Director of each stock exchange to be appointed, removed and
terminated with the approval of the commission.
The position of vice-chairman of the exchange to be abolished
The chairman to be elected by the Board from amongst the elected directors.
Refraining from engaging the auditors for other services except those specifically
permitted.
Rotate the firm of auditors after every five years (with forbearance in this respect
granted up to December 31, 2003).
4.3.20.2 Revised Arbitration Procedure : In order to ensure expeditious resolution of
investors’ complaints, the Commission has approved a two-tier arbitration procedure for
the KSE. Under the new procedure, all claims and disputes of more than Rs. 0.5 million,
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which are not amicably settled otherwise, should be referred to an Advisory and
Arbitration Committee (AAC) for resolution or decision. The Committee consists of three
members, namely, one member director, one non-member director and the Managing
Director. A claim or dispute could be referred by the AAC to a panel of arbitrators.
However, claims and disputes of up to Rs. 0.5 million would be resolved or decided by
the Managing Director of the exchange. It is expected that introduction of the new
arbitration procedure will have a positive impact on engendering investor confidence.
All stock exchanges have been directed to make certain changes in their
governance structure to ensure that the exchanges are managed in accordance with
internationally accepted norms and in the best interest of the capital market. Stock
exchanges have been advised to follow international standards in governance to
strengthen their risk management. The initiatives taken by the SECP are aimed at
ensuring that the exchanges conduct themselves as a national institution fully protecting
the interests of investors who are major stakeholders in the system. Despite consultations
with all concerned parties, implementation of the Code was resisted by some elements in
the private sector and the Commission had to stand firm to ensure that the initiative was
not derailed.
89
4.3.21 Electronic Stock Exchange:
Efforts are underway for the establishment, for the first time in Pakistan, of an
Electronic Communication Network (ECN) as an automated trading system that may
function as the fourth stock exchange. The ECN, to be operated by PEX Limited, a
subsidiary of Jahangir Siddiqui, who has been in the securities and brokerage business in
Pakistan since 1970, would be a self-regulatory entity. Providing investors with enhanced
flexibility and reduced trading costs, as well as competition to the established securities
exchanges. Trading under this system would require the simultaneous presence of shares
and the money to buy these, thus minimizing the role of 'Badla'. An ECN would be free
to trade in shares of companies that are already listed with the stock exchanges and can
enlist new companies subject to fulfillment of requirements of the listing regulations of
the SECP.
The establishment of an ECN in Pakistan would provide significant advantages to
a variety of subscribers through increased opportunities for trading, efficiency of
execution, i.e. lower costs and enhanced liquidity, thus imparting greater depth to the
capital market.
The cost-less system of ESE will not be limited to Pakistan. There are no
geographical boundaries attached to it. ADB fully supports the establishment of the new
Electronic Networks (ECNs) and Alternative Trading Systems (ATS) and has explicitly
made this a requirement under the ADB-financed Financial (non-bank) Markets and
Governance Program (FMGP) approved in December 2002.
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Stockbroker community at Karachi and Lahore has been up in arms since the time
this decision was announced. Brokers allege that the decision by the previous chief
regulator was taken "in haste" and that it lacks transparency and smacks of favoritism.
Almost all the leading members of KSE have criticized the non-transparent manner in
which one company was allowed to establish Electronic Stock Exchange to the exclusion
of others. In the US and other countries, it is a collective business in which a large
number of companies jointly own and operate such ESEs.
4.3.22 National Clearing & Settlement System (NCSS):
The National Clearing Company of Pakistan Limited was incorporated on July 3,
2001 and has commenced operations w.e.f. December 24, 2001 and so far 150 scrips
have been added to the NCSS. This project has been prepared with the assistance of the
ADB.
It is an electronic system developed to replace the individual clearing houses
operated in each of Pakistan's three Stock Exchanges by a single entity. The consolidated
and geographically neutral Clearing House is located at Karachi, with sub - offices at
Lahore and Islamabad. None of the regional markets, including India have such an
advanced system of clearing and settlement.
Those eligible to become the clearing members in NCSS include: stock broker,
bank, company, corporation or institution falling under section 3A of the Banking
Companies Ordinance 1969, investment company or asset management company as
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defined by the company rules, and any other person, company, corporation or institution
in such class as National Clearing Company Pakistan Limited (NCCPL) Board may
determine.
The system is based on rolling system on T+3 based on Continuous Net
Settlement (CNS). By adopting the above system design the ratio of trade with settlement
has improved and in turn speculative trade is expected to reduce. Under the NCSS,
Continuous Net Settlement (CNS) is the main settlement option available to settle
trades/transactions received from different sources. CNS is understood to mean a system
in which the clearing members would have the option of carrying over their positions to
the next settlement day as opposed to the present system in which settlement of trades has
to be done at the designated settlement day. Previously, if clearing members were short of
funds or securities, they had to resort to borrowing. With CNS, clearing members have
the option of carrying over their positions to the next settlement day (subject to
allocation, if any), thereby rolling over their position without the constraint of delivery or
payment except of a mark to market charge.
In CNS, clearing members are required to settle only with the clearinghouse
rather than the counter party, which would minimize the risk of default. Other settlement
options under NCSS include: Balance Order Settlement (BO) and Trade for Trade
Settlement.
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The platform for the NCSS was created in full consultation with market
participants, investors and brokers, and adjustments were made to the system as called
for. Effective information systems were installed within the SECP.
NCSS has provided much required stability to the market by capping the systemic
risk to a great extent. With the launch of the System, the capital market has gotten to
work under standard rules and regulations and it has also made intra-stock exchange
settlements possible. Previously, all three stock exchanges of Pakistan operate their
individual clearing houses for trades on their respective exchanges. Other features of the
NCSS include a mark-to-market mechanism, formal stock lending and position financing.
4.3.23 National Saving Schemes (NSS):
The reforms of the National Saving Schemes (NSS) were launched to deepen
the capital market and reduce the cost of government borrowing. To achieve this
objective, institutional investors were barred from purchasing NSS instruments from
March 2000 and interest rates on NSS instruments have been reduced by an average of
5.5 percent since May 1999. Consequent to the above measures, there has been
diversion of deposits from NSS instruments inter-alia to other institutions including the
market based security namely Pakistan investment Bonds (PIB), following decline in
the investment in NSS. In an effort to further rationalize the rates on NSS instruments,
the yield of Defense Saving Certificates (DSCs) has been linked with the PIB of similar
maturity since January 1, 2001, while the rates on the other NSS instruments have
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become market based since July 1, 2001, which will subsequently b e adjusted on semi-
annual basis.
The Central Directorate of National Savings (CDNS) is an attached department of
the Finance Division and performs deposit bank functions by selling government
securities through a network of 366 savings centers, spread all over the country. As of
March 31, 2003 there were a total of about 4.3 million investors with National Saving
Schemes (NSS). The seven Savings Schemes currently in operation include: Defence
Savings Certificates, Special Savings Certificates/Accounts, National Deposit
Certificates, Savings Account, Regular Income Certificates, Mahana Amdani Account,
and Prize Bonds. A new saving scheme entitled “Pensioners’ Benefit Account” was
launched during 2002/2003.
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Table 4.7 NET ACCRUALS BY NSS (Rs Billion)
J
uly - March %
1999-00 2000-01 2001-02 2001-022002-
03 Change
1 Defense Saving 41.2 16.6 22.
0 13.2 14.7 5.1
Certificates (43.10
) (32.5
) (24.1
) (26.0) (19.
9)
2 Special Saving 19.4 9.4 36.
4 21.5 41.
3 19.8
Certificates Registered
(20.30)
(18.4)
(39.8) (42.4)
(55.8)
3 Regular Income 26.1 8.6 11.
0 7.8 -11.9 -6.3
Certificates (27.30
) (16.8
) (12.0
) (15.4) (-16.1)
4 Special Saving 5.50 3.6 4.
3 -0.2 2.9 6.1
Accounts (5.80
) (7.0
) (4.7
) (-0.4) (3.
9)
5National Prize Bonds -0.03 10.4
11.6 6.9
18.0 17.5
(-0.03) (20.3
) (12.7
) (13.6) (24.
3)
Others 3.4 2.5 6.
1 1.5 9.
0 50.7
(3.60
) (4.9
) (6.7
) (3.0) (12.
2)
Grand Total 95.5 51.1 91.
4 50.7 74.
0 8.4
(100
) (100
) (100
) (100) (10
0)
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Note: Figures within brackets represent share to total Source: Directorate of
National savings
In 2003, the real rates of return under the NSS were still attractive as compared
to other deposit schemes. Since the weighted average real deposit rates of the schedule
banks remained low (around 2.8%), the NSS still offers the most attractive rate of
returns to the depositors. This is the main reason why net accruals under the NSS have
increased by 46.0 percent in the first nine months of 2002-03, over the same period of
last year.
In an attempt to restructure the National Savings Organization on modern lines,
computerization process is underway. Procedure of maintenance of record at National
Savings Centers has been revised threadbare to ensure proper maintenance of record
and to make it computer friendly. Due attention and importance is being given to the
job of automation of National Savings accounts and the work is expected to be
completed in line with the commitment of the Federal Government with the
International agencies.
4.3.24 Internet Stock Trading:
The Lahore stock exchange earned the distinction of being the first stock
exchange of the country to venture into the most modern methodology for the proportion
of trading and investment activity in listed shares by adopting Information Technology.
Thus the Lahore Stock Exchange has emerged as one of the few bourses among the Asian
emerging markets to introduce the internet system of trading, thereby bringing the
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progress of Information Technology in Pakistan into limelight. Investment interest in the
stocks of the listed companies is going to be extended to about 300 cities and towns in
Pakistan where Internet facility has been established. As a result, investment interest
especially among retail investors is likely to be expanded tremendously and thereby the
image of stock exchanges in Pakistan would be enhanced to a great extent. The
development of Internet system of trading was achieved through in-house preparation of
software known as Ultra Trade.
The introduction of Internet system trading activity in stocks and shares would
now contribute to speedy promotion of investment activity among retail investors in the
country. The brokerage houses are likely to be induced to extend their salesmanship in
stock and shares to relatively smaller towns where Internet facility is available in the
contrast with their present confinement in the cities where the stock exchanges are
located. The process is going to accelerate the pace of capital formation in the country.
4.3.25 Securitization:
Companies (Asset backed Securitization) Rule (1999) confers certain advantages
to the originator or the company whose assets get securitized. It is an emerging option for
NBFI’s to raise capital, which is relevant in the current state of financial markets.
Technically speaking, this allows a company to realize its discounted future revenues up-
front, which can then be used for long-term investment. However, other than monitoring
and rating of the public company, the financial institution willing to lend against such
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assets will bear the risk of any changes in collateral value. This should force banks and
NBFIs to improve their risk management capabilities.
SECP has been able to see its way around a few impediments and approve the
first securitization transaction, which should be a harbinger for others to follow.
4.3.26 Leasing Industry:
The leasing industry, represented by 29 leasing companies, is an important
segment of Pakistan’s financial sector. It has experienced commendable growth over the
years and has proved to be an alternative source of finance to banking. Some of the
leasing companies, however, are inadequately capitalized. To allow leasing companies to
access alternative long-term funding sources, the SECP issued the Companies (Asset
Backed Securitization) Rules, 1999, which provided the legal and regulatory framework.
Under the Program, the SECP has stipulated a minimum paid-up capital of PRs200
million (about $3.2 million) applicable to all leasing companies operating in Pakistan.
Leasing companies have made a significant contribution towards development of the
financial sector. They have also played an important role in the development of small and
medium scale enterprises in Pakistan and remain a significant player in the vehicle
financing business
The leasing sector has witnessed a number of cross-sector mergers during the past
few years as well as within the sector. This was due to the efforts of the Specialized
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Companies Division of the SECP, which has been emphasizing the need for mergers
among NBFIs for enhancing their capital base, achieving economies of scale, and
improving competitiveness and effectiveness.
The measures taken by SECP to promote consolidation of financial institutions
have become extremely important for the sector’s revival. However, to improve the
future prospects, the leasing companies need to broaden their scope and develop
innovative products together with initiating vendor financing arrangements with suppliers
of capital equipment, operating leases, and cross-border leases. The presence of
commercial banks and development finance institutions in the market has impacted the
leasing companies’ margins, but their ability to offer “big-ticket” leasing has enhanced
the acceptability of leasing options.
4.3.27 Facilitation Of Investors:
4.3.27.1 Improved Communication Linkages: To broad base the capital market,
linkages to cities other than Karachi, Lahore and Islamabad are to be established. The
SECP is in the process of developing a policy framework so that the operation is
extended to other major cities. Software at all the stock exchanges is to be up-graded so
that trade from small cities through the communication linkage is facilitated. An
appropriate system design is to be prepared on the above basis.
4.3.27.2 Investor Education: Various efforts are underway to educate investors about
the significant aspects of investing in securities. SECP has published a series of Investor
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Guides to educate existing and potential investors about the investment risks and rewards,
the importance and significance of financial planning and, most importantly, the rights
and responsibilities of investors and the recourse available to them. The preparation of
the Investor Guide series is a part of SECP’s investor awareness program. Information
asymmetries provide undue advantages to certain market participants in case of market
failure. SECP, therefore, aims to achieve maximum dissemination/ disclosure of
information to all investors.
4.3.27.3 Beneficial Ownership: In order to protect the interests of minority shareholders
and to discourage the management of listed companies from making windfall gains on
the basis of privileged inside information, every director, chief executive, management
agent and person holding 10 percent or more shares in a listed company is required to file
certain prescribed returns for beneficial ownership. Also, any gains made by beneficial
owners in transactions completed (purchase and sale or sale and purchase) within a six-
month period are to be reported to the issuer and the Commission and tendered as
stipulated in the law.
4.3.28 Mutual Funds:
Mutual Funds were introduced in Pakistan in 1962, with the public offering of
NIT, which was an open-ended mutual fund in the public sector. The establishment of the
Investment Corporation of Pakistan (ICP) in 1966, which subsequently offered a series of
closed-end mutual funds, followed this. ICP has so far floated 26 closed-end mutual
funds. Later, the government also allowed the private sector to establish mutual funds.
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Currently there are four open-end and twelve closed-end mutual funds under private
sector management. The mutual fund industry, with a total size of PRs26 billion,
represents about 6% of the total market capitalization of the stock market. Mutual funds
in Pakistan stand at about 2.5% of bank deposits, which is quite low compared to other
countries in the region.
Significant amendments have been made to both the Investment Advisors Rules
applicable to closed-end mutual funds and the Asset Management Companies Rules
applicable to open-end mutual funds. The following improvements in the mutual fund
industry are noticeable:
Raising disclosure and reporting requirements.
The rules now provide for the establishment of sector-specific funds, giving
investment managers a considerable amount of flexibility in their fund
management approach.
SECP gave approval to the country’s first fixed-income securities fund in 2002.
An important development in the sector was the extension of the SECP’s
regulatory jurisdiction over the two public sector mutual funds, ICP and NIT.
A uniform tax rate is now applicable to both private and public sector mutual
funds.
Registration of Mutual Funds Association of Pakistan.
However, certain anomalies in government policy still remain. For instance, zakat
is charged on private sector mutual funds but not public sector mutual funds, and only
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units of the National Investment Trust Limited (NIT) qualify as investments under the
statutory liquidity ratio of banks and non-bank financial institutions (NBFIs). The overall
performance of mutual funds, however, has been less than satisfactory, mostly due to the
under performance of the stock market until late 2001.
4.3.29 Insurance Sector:
One of the most significant achievements under the Capital Market
Development Program was the promulgation of a new Insurance Ordinance in 2000,
which replaced the Insurance Act of 1938. The Ministry of Commerce (MOC) drafted
the insurance ordinance through extensive dialogue with the insurance industry and
market participants. The new ordinance involves:
Higher capitalization and solvency standards.
Sound and prudent management.
Market conduct rules for safeguarding the interests of policyholders.
A comprehensive adjudicatory system, supported by small disputes settlement
committees, tribunals, and an insurance ombudsperson.
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Entering into reinsurance arrangements with re-insurers that have a minimum “A”
rating.
All insurance companies have recently been directed to follow the Good
Corporate Governance Code in the same way as the listed companies do.
Insurance industry in Pakistan is not in a good condition. Out of 43 insurance
companies, the stock of only 18 companies was traded at par or above par on 1 st January
2003. The remaining 25 companies’ stock was traded below par.
It is noteworthy that insurance companies were asked to enter into reinsurance
arrangements with re-insurers that had a minimum “A” rating and later those companies
that were unable to do so, possibly due to reduced global insurance capacity, were asked
to obtain a satisfactory “claims paying ability” or “financial strength” rating from a
recognized rating agency. Insurance companies that could not comply with either
requirement were barred from engaging in further insurance business, thereby saving the
general public from being offered potentially unworkable insurance policies. The
Commission was also able to enforce the minimum capital requirement imposed on
leasing companies. The sector is largely in compliance with this stipulation. Further, in
order to clean up its corporate registration records, the Commission launched and
successfully implemented, carefully devised schemes to regularize the default of private
and non-listed public companies with respect to their reporting requirements and to
facilitate dormant companies exit out of the register of companies.
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4.3.30 Pension & Provident Fund:
Pension funds and other contractual savings instruments are major players in the
stock markets. Unfortunately, this was not the case in Pakistan when SECP initiated some
steps to create incentives for pension funds to actively invest in the capital market. The
pension sector in Pakistan is fragmented. The Government has yet to develop a
framework for developing a pension and provident fund industry. Government employees
with twenty years service (twenty five for military) are entitled to a pension, which is on
a defined benefit basis, adjusted partly for inflation and tax-free. This scheme is un-
funded. The largest scheme is the Employees Old-Age Benefits Institution (EOBI), a pay-
as-you-go scheme. EOBI assets are expected to rapidly deplete as the scheme approaches
maturity and is not fiscally sustainable in the long term.
The regulation of the private pension fund industry is now vested with the SECP.
The commission has relaxed the investment ceilings for provident funds that can now
invest up to 30% of their portfolio in the stock market. It is also considering the
possibility of fixing a minimum investment by these funds in the capital market.
Pursuant to the pronouncement made in the 2001 budget, the SECP has submitted
a proposal for pension reforms and corresponding legislation to MOF, but substantial
effort is required for developing a proper legal, regulatory, and tax framework for the
sector.
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It is hard to comment on how much investment these changes will bring.
However, even a smaller percentage, say five percent of provident funds, can bring a lot
of liquidity and growth in the stock market. The problem at the moment is not just
allocation of funds but it is the lack of professional expertise related to fund management
in Pakistan. In order to maximize return on pension funds, these funds have to hire
professional fund managers to make rational and profitable investments.
4.3.31 Leasing Sector:
As financial intermediaries providing medium and long term financing, leasing
companies have made a significant contribution towards development of the financial
sector in the country. Leasing companies have also played an important role in the
development of small and medium scale enterprises in Pakistan and remain a
significant player in the vehicle financing business. Previously, establishment of
various small leasing companies and entry of other financial institutions into the leasing
business had resulted in a fragmented sector with limited opportunities for growth.
Moreover, leasing of plant and machinery was adversely affected due to increase in the
number of sick units in textile and cement sectors. The capital base of a number of
leasing companies was, therefore, eroded due to the large amount of provision that was
needed against such non-performing assets.
Despite frequent reduction in interest rates and persistent slow down in
economic activity, the leasing sector has demonstrated reasonable growth. However,
the sector continues to be highly concentrated as six leasing companies accounted for
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more than 70 percent of total assets of the sector. The following regulatory actions have
been introduced in the leasing sector:
Requirement for Increase in Paid-up Capital: By the end of 2003, it is
expected that almost all the leasing companies would have met the minimum
capital requirement of Rs 200 million. The enhanced capital base is expected to
result in greater financial stability, improved resource mobilization capacity and
economies of scale to enable leasing companies to compete effectively with larger
financial institutions undertaking leasing business.
Mergers and Consolidation: Consolidation in the sector is on the rise and
expected to continue as a few more mergers are in the pipeline while some are at
an advanced stage of negotiations. These include not only intra-sector mergers but
also cross-sector mergers involving modarabas and investment banks. It is
anticipated these would result in improving resource mobilization potential and
operational efficiency of leasing companies due to strengthening of capital base
and economies of scale, respectively.
Suspension of Permission to Issue Certificate of Investment (COIs): The
Commission suspended the permission to issue Certificate of Investment (COIs)
of several leasing companies since their credit ratings were below the minimum
investment grade and issuance of COIs by such companies is in violation of the
Leasing Companies (Establishment and Regulation) Rules, 2000. In case these
companies fail to obtain a satisfactory investment grade credit rating within a
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period of two years, the permission to issue COIs will be cancelled. During the
two-year time period, these companies have been advised not to issue any new
COIs or rollover the existing COI deposits upon maturity.
Permission to Investment Banks and DFIs to Undertake Leasing Business:
Licenses to undertake leasing business have been accorded to DFIs and
Investment Banks in terms of Rule 18 of the Leasing Companies (Establishment
and Regulation) Rules.
Appointment of Administrator: In 2002, special audit of a leasing company
revealed gross misappropriation and misapplication of funds by its management.
Therefore an Administrator has been appointed according to the Company’s Act
to ensure that the management of leasing companies presents a true and fair
picture.
Holding of Annual General Meetings: Companies are required to hold their
Annual General Meetings (AGMs) within six months of the close of the financial
year.
Inspection & Investigations: SECP, on a regular basis, carries out investigations
of leasing companies and inspects their books of accounts and interim statements.
It also passes strict action against the auditors in case they do not perform their
duties properly.
4.3.32 Modarabas:
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The modaraba is an Islamic corporate form that is essentially akin to a two-tier
fund structure. In a modaraba, one party (the modaraba management company)
contributes its skills and efforts while the other (the modaraba certificate holders)
provides the required funds. The profits earned in the business are shared between the
management company and certificate holders on a pre-determined basis. A modaraba
may be for a specific purpose or multi-purpose, and may be perpetual or floated for a
specified period.
The difficult operating environment prevailing in the recent past has had an
adverse impact on the performance of a number of modarabas. However, despite the
persistent economic slow-down, the sector, overall, has performed reasonably well. As
per the last audited financial results, the dividend payout of the modaraba sector has
been quite encouraging.
Fiscal incentives announced in the Finance Ordinance, 2002 for leasing
modarabas are expected to give a significant boost to the performance of the sector
through tax deferrals and reduced current tax liabilities. Moreover, better monitoring
and surveillance methods, recently instituted by the Commission, have resulted in
improved compliance by modaraba management companies with the Prudential
Regulations and observance of significantly better disclosure standards.
Certain amendments have been made in the Modaraba Ordinance and Modaraba
Companies and Modaraba Rules, 1981, which are as follows:
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Increase in paid-up capital requirement for modaraba companies
De-registration of Modaraba Management Company if it fails to float a modaraba
within a reasonable time period.
Enabling provision to allow extension in filing/ circulation of annual accounts
under special circumstances
Provision to allow voluntary winding up of perpetual modarabas as against
winding up through the Modaraba Tribunal
Rotation of statutory auditors after every five years.
Rationalization and synchronization of Modaraba Companies and Modaraba
Rules, 1981 and regulations with the provisions of Modaraba Ordinance.
4.3.33 Demutualization Of The Stock Exchanges:
In response to technological advances, globalization, growing competition and,
more significantly, concern for investors’ interests, stock exchanges worldwide are
embarking upon a process of demutualization. Out of the 52 exchanges, represented at
the 2001 meeting of the International Federation of the Stock Exchanges (FIBV), 32 had
demutualized while 20 had approved plans for demutualization.
Demutualization transforms an exchange from an entity owned by its members
into a commercial, shareholder-owned company. A demutualized stock exchange has a
clear commitment to generate competitive returns for its shareholders as well as to
protect the interests of all its customers and those of the broader investor community.
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All members of the FIBV have either completed, or are in the process of,
demutualization. The three stock exchanges in Pakistan are, at present, considering
demutualization and are engaged in analyzing different models/ structures of
demutualized exchanges.
The Commission has approved the establishment of National Commodities
Exchange Limited (NCEL), for trading in future contract in commodities. The NCEL is
the first demutualized exchange and will be sponsored by the three stock exchanges of
Pakistan.
4.3.34 Credit Rating Agencies:
Credit rating reports serve as useful tools for investors to make informed
investment decisions in respect of various listed and non-listed debt instruments. Credit
ratings are also one of the factors considered by the regulator in approving issues of
corporate debt for public subscription.
The functioning of credit rating agencies was regularized by issuing them
licenses, based on performance and compliance with the registration criteria. Issuers of
corporate bonds and term finance certificates (TFCs) were required to get these
instruments rated by recognized credit rating agencies. Similarly, all the financial
institutions are required to get credit rating for their financial standing.
The Commission has made it obligatory upon credit rating agencies to notify
ratings in newspapers within two working days of issuance of ratings and provide
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copies of rating reports to the relevant stock exchanges and the Commission within 10
working days of the notification of such ratings. Any change in the rating also needs to
be intimated immediately.
Lately some amendments have been made in The Credit Rating Companies Rules,
1995, which are as follows:
Prior approval of the Commission is required for replacing the chairman and the
CEO of a rating agency.
The CEO of a rating agency has been prohibited to hold similar position in any
other entity.
The Commission may exempt rating agencies from the requirement of technical
collaboration or joint venture arrangements, after a period of five years. This
exemption may be granted by the Commission upon being satisfied with the
capabilities and performance of the rating agency.
Rating agencies are required to inform the Commission before undertaking the
rating assignment of an entity in which any of its directors is holding a
directorship by virtue of nomination by the Federal or Provincial Government.
Such a director would also be required to submit an undertaking that he would not
take part in the rating process of that entity.
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SUMMARY, CONCLUSION& RECOMMENDATIONS
The Asian Development Bank (ADB) is promoting vibrant and efficient financial
markets in Pakistan and its Capital Market Development Program was the first major
intervention to reform the non-bank financial sector implemented over 1997-2001. The
intention behind these efforts of ABD was to create a policy environment to enhance
competition and a level playing field, strengthen governance, institutions, regulations,
and supervision of the securities market, improvement and modernization of securities
market infrastructure and its integration, induce development in the corporate debt market
and the leasing industry, introduction of reforms in the mutual fund industry and
promotion of contractual savings through reforms of the insurance sector and pension and
provident funds.
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In 2002, when the second phase of the reforms (Financial Markets and
Governance Program) was initiated, the major aim of ADB was to strengthen investor
confidence through improved governance, transparency, and investor protection and
improve operational efficiency and risk management of intermediaries thus reducing
financial sector vulnerabilities.
The ADB’s program is in agreement with Pakistan's financial systems - a market-
oriented, predominantly private owned banking and financial system that operates under
a strong regulatory framework, supported by an effective legal and judiciary system,
mobilizing the capital needed to finance rapid private sector growth, and improving
access to financial services by the poor.
ADB’s strategy for the industry and financial sectors in Pakistan emphasized
concurrent support for reforms of the capital market and of trade and industry. Based on
the direction of this strategy, the Program appropriately analyzed and addressed
impediments in the capital market. The program design, based on mission studies and
extensive discussions with the Government, was sound and highly relevant. The Program
aimed to broaden and deepen the capital market to encourage investment and savings.
Reforms of the securities markets, encompassing both primary and secondary markets,
were aimed to improve the prospects for issuers to mobilize long-term resources and
provide alternative opportunities to suit their preferences.
5.1 IMPLEMENTATION
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Overall, implementation arrangements were satisfactory. MOF acted as the
Executing Agency for the Program. It coordinated and monitored the Program and
administered the utilization of loan proceeds. Support to MOF was provided from the
SECP on matters pertaining to reforms of the stock exchanges, leasing industry, and
mutual funds and from MOC on matters related to insurance industry reforms. The SECP
gave full cooperation to program implementation, though delays were experienced,
mainly in resolving complex technical issues. MOC, in some cases, was slow to take the
necessary action for implementing policy changes related to the insurance industry, often
due to lack of up-to-date skills and knowledge of recent best practices in the international
insurance market. Program implementation benefited from very tight supervision by
ADB staff who made frequent visits and maintained policy dialogue throughout
implementation.
The Technical Assistance (TA) loan originally had four components: (i)
Institutional strengthening of SECP through assisting in formulation of new rules and
regulations, developing prudential norms and monitoring compliance, and designing
formats of inspection reports; (ii) Development of a self-regulatory framework for the
stock exchanges, Mutual Fund Association, and Pakistan Leasing Association; (iii)
Development of the NCSS through examining the feasibility of integration with CDC,
and through designing its platform as well as preparing the regulations, procedures, and
operational manuals of the NCSS; and (iv) Development of the secondary debt market on
the OTC market. A fifth component for privatization of mutual funds was added in
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January 2000, to provide technical inputs to resolve the intricate legal and financial issues
required for privatization of NIT and ICP.
Of the four original components, the institutional capacity building of the SECP
and support for developing the NCSS provided support critical to program
implementation. The regulatory framework, assisted by the regulations expert, gave the
SECP a solid basis for formulating comprehensive rules and regulations. The information
technology support given for establishing the NCSS was indispensable for its
operationalization. On the other hand, actual implementation of the self-regulatory
framework, and establishment of OTC market for secondary bond market were assessed
to be premature in the respective studies conducted, given the current stage of capital
market development in Pakistan. The fifth component supported due diligence for the
privatization of NIT and ICP and was valuable in assuring progress.
The Program brought an important package of reforms to Pakistan, and initiated
the process of developing a sound and efficient capital market. It was broad based and
touched on all integral components of the capital market. It was successfully
implemented and produced some concrete results. At the time of the program closing date
of 31 October 2001, of the 58 policy actions under the Program, the Government
achieved full compliance with 51, substantial compliance with two, partial compliance
with three, while two of the policy actions were considered inappropriate and not
implement able.
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Despite considerable interaction and cooperation with the Government, execution
of the Program proved to be more complex than originally envisaged. An international
firm was contracted to provide consulting services. The recruitment of the consultants
was delayed by approximately 10 months to January 1999 due mainly to the lengthy
consultant selection process and protracted contract negotiations because the SECP,
acting as the implementing agency, was unfamiliar with ADB procedures. The time-
consuming nature of consensus building for designing the NCSS’s format and the
political instability in the region after 11 September 2001 further delayed TA
implementation. Moreover, the reprioritization of the agenda by the new SECP
chairperson since March 2000 affected the implementation, as adjustments were needed,
particularly for inputs from the regulations expert. The mid-course adjustments in the
program were mainly due to the realization of the relative importance of each component
at the time of implementation.
The performance of the consultants was satisfactory. Solid efforts were made by
the regulations expert to consult both the Executing Agency and the market stakeholders
in the formulation of market regulations, while promoting understanding of modern
market practices. Effective information systems were installed within the SECP. Overall,
the consultants possessed the capacity to provide solid technical advice as well as
flexibility to meet the client’s needs.
Although political disruptions delayed the progress of program implementation in
difficult macroeconomic circumstances, strong commitment of MOF as the Executing
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Agency and solid support from the SECP as the implementing agency prevented the
Program from derailing and enabled its successful completion. The need for strong
ownership of the Program by the executing and implementing agencies was confirmed, as
many problems not foreseen at the time of program formulation were resolved through a
concerted effort of the officials concerned.
5.1.1 Performance Of Ministry Of Finance:
MOF was proactive in the process of implementing reforms. It was instrumental
in having the SECP Act, 1997 enacted and the SECP’s becoming operational from 1
January 1999. It also coordinated with the provincial governments to enact the reduction
in stamp duty rates. Meetings were regularly held at MOF for reviewing and monitoring
progress of implementation and resolving contentious issues. MOF, despite change of
key staff following a change of government, continued to show strong commitment to
policy reforms and senior officials were readily available for policy discussions with
ADB staff. MOF has generally met loan administration requirements and its performance
was satisfactory. However, in more politically sensitive areas of reform involving
different government authorities, MOF’s role was inevitably limited to that of a mediator.
MOF’s commitment to reform overcame numerous political disruptions, and a process
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for building a market system to provide risk and term financing to the economy was set in
motion.
5.1.2 Performance Of SECP:
Of the two agencies supporting MOF, the SEC provided quality support. It
effectively liaised with the three stock exchanges in executing structural reforms and
coordinated effectively with other stakeholders in the capital market for implementing
several difficult policy actions. Though there remains sufficient scope for institutional
strengthening of the SEC, as its mandate has been enlarged to include regulation of the
insurance, pension, and NBFI sectors, the SEC’s commitment to the Program was
instrumental in maintaining the momentum of reforms during the 4 years of program
implementation. Support given by MOC was in many cases limited, due mainly to staff
constraints and MOC’s lesser association with the overall Program.
The period of about four and half years in the life of the Commission has been
characterized by momentous development in terms of reshaping of the legal framework
and regulatory system, development of market institutions and infrastructure, and
streamlining of government policies in this regard. Some of these measures constituted a
fundamental departure from the past and as a result, the role of SECP has become much
more visible in implementation of these radical capital market reforms.
5.1.3 Performance Of ADB:
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ADB provided regular monitoring of the Program and regularly sent review
missions. Each visit closely monitored the status of Program implementation, identifying
impediments and engaging government counterparts in intensive discussions on measures
to resolve them within the given time frame. Through program implementation, ADB
established a close working relationship with key program counterparts. ADB’s
responses to the Government’s requests were quick and approvals and disbursements
were promptly undertaken. Significant efforts were made to support capacity building of
the SEC, an integral component of the Program, by administering the TA loan flexibly.
ADB staff played a crucial role in advancing policy dialogue and supported
implementation of several reform components. Given the broad and complex agenda of
reforms under the Program and ADB resource constraints, additional technical inputs
could have further facilitated resolution of sensitive and multifaceted policy issues.
ADB’s extensive and in-depth discussions with government officials on the
program design at the time of its formulation have resulted in the successful resolution of
all and any problem that hindered the implementation process. Similar efforts should be
made mandatory in processing future assistance, particularly in view of the economic and
political instability in the sub region.
The scope of the ADB’s Program was ambitious. Consequently, it became broad
based and in some instances failed to incorporate essential details. The Program required
substantial staff resources to make adjustments and fine-tune the policy action during the
process of implementation. In some cases, insufficient staff resources impeded timely
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assistance for program implementation. Moreover, many of the risks identified at the
time of program formulation materialized, and overcoming them proved more complex
than assumed. The reform program also raised awareness in the Government and among
capital market stakeholders, including market participants, of critical issues of
governance, transparency, efficiency, and best market practices. Its overall rating is
successful.
5.1.4 Support From Stock Exchange:
No reform process can be successfully implemented and its effects fully realized
unless all the concerned parties work together in harmony to ensure its development.
Similarly, when the capital market reforms were initiated by ADB with the MOF as the
executing agency and the SECP as the regulatory body, each of the concerned parties
knew that they would be quite useless without support from all the stock exchanges of the
country, especially the KSE that dominates the equity market of Pakistan.
In the initial period, when the SECP was formed and it started exercising its
powers in areas that the members of the stock exchange considered as theirs, there was a
lot of friction. The people belonging to the equity markets, the brokers, registrars,
executive members of the exchanges were quite resistant to the changes being brought by
SECP. The reason behind this was that they considered it a violation of their premises
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and felt that their freedom to do whatever suited them was being threatened. This
resistance to change impeded the growth of the capital markets. However, with the
passage of time, when the full impact of these reforms were realized along with improved
turnovers and market capitalization at the stock exchanges, they were forced to change
their thinking and now the Commission has the full support of the equities market
community.
Representatives from ISE and LSE state that their reason for supporting the
reforms is vested in the belief that these are the means of achieving development,
expansion and modernization of the capital markets. The stock exchanges are committed
to improve their operational efficiency and it is believed that the capital market reforms
will go a long way in transforming the stock exchanges into vibrant institutions capable
of meeting the challenges of the new millennium. However, the truth of the matter is that
the members of the stock exchange are unwilling to implement self- regulatory
mechanism beyond a certain level. So the SECP has to assert its authority.
The Stock exchanges have initiated a process to professionalize their
management. In organizations that worked for years within a closely-knit group of
people, the transition has been difficult. The SECP expended considerable effort in
convincing the stock exchange members of the long-term benefits of professionalizing
their management and opening up the board to outside directors. Recently, under SEC
direction, the stock exchanges have amended their articles of association to require prior
approval of the SECP in appointing and removing their chief executive. This measure is
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expected to strengthen the independence of the chief executive. As the managements of
the stock exchanges attain greater degrees of professionalism and independence, the
SECP may delegate greater authority to them for the sake of achieving an optimum
balance between direct regulation and self-regulation.
5.2 EFFICACY OF CAPITAL MARKET REFORMS
The long-term impact of reforms on the overall performance of the capital market
still remains to be seen. During the 4 years of program implementation, political and
macroeconomic developments were the overriding factors affecting Pakistan’s stock
market. The Program did, however, achieve definite results in important components of
the capital market. For example, the modernized infrastructure of the stock exchanges, as
well as implementation of the first phase of the NCSS, are important achievements that
are bound to have positive long-term effects. Introduction of a T+3 trading system on a
rolling settlement basis has discouraged speculative trading and reduced systemic risk in
the market. The NCSS will help in improving efficiency of the market and in integrating
the three stock exchanges. With these developments, a number of recommendations of
the Group of Thirty countries (a private sector group composed of representatives of
leading banking and securities firms concerned with the working of the international
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financial system) have been successfully implemented. However, the general perception
that members of stock exchanges continue to influence management decisions, at times at
the cost of investors’ interests, still remains. The SECP and the boards of stock exchanges
must take concrete actions to enhance the professional standards of market participants,
the transparency of stock market transactions, and the legal framework for investor
protection.
The regulatory measures carried out by the Securities and Exchange Commission
of Pakistan (SECP) during the last four years have not only received international
acclaim but has also made a very positive impact on the stock market and the corporate
sector in Pakistan. The effectiveness of the regulatory system is evident from the fact that
Pakistan's stock market has been termed as one of the best performing markets in the
world with no systemic issues despite several shocks. During July-May 12, 2002-03 the
Karachi Stock Exchange has also remained the best performing market among the
leading stock markets in the world. As documented in Table and Fig: out of 13 leading
stock markets in the world, the KSE share index increased by 74.6 percent in terms of US
dollar during July-May 12, 2002-03.
Table 5.1 REGIONAL MARKETS INDEX CHANGE IN USD DURING JULY-MAY 12, 2002-03
(Index level in USD)
Index Level in Respective Currencies % Change in USD12 May 2003 30 June 2002
Pakistan 2973.31 1770.12 74.60Sri Lanka 844.29 711.36 17.32
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Malaysia 633.95 646.32 -1.91Indonesia 473.93 505.01 -2.67Thailand 383.49 389.10 -3.33India 2942.78 3244.70 -5.96Philippine 1061.40 1156.35 -11.06China 1531.87 1732.76 -11.59Singapore 1327.42 1552.98 -12.55Hong Kong 9155.57 10598.55 -13.61Korea 631.04 742.72 -14.15Taiwan 4261.02 5153.71 -20.14Japan 8221.12 10621.84 -20.72
Source: Elixir Securities Pakistan
Figure 5.1 REGIONAL MARKETS INDEX (%) CHANGE DURING JULY-MAY, 2002-2003
Source: Economic Survey, 2003
The Program had no direct environmental impact. Indirect environmental and
socio-cultural impacts through economic growth and poverty reduction are positive.
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The market friendly measures introduced during the last four and half years had a
significant impact on investor confidence and the stock market is no longer viewed as
having any resemblance with a casino, attracting only die-hard speculators, according.
The structural changes brought about by the government have been quite successful in
restoring investors' confidence in the equity market. The market has clearly attracted
genuine investment as is evidenced by the fact that actual settlement has risen from about
one to two per cent of trades in the early part of year 2000 to around 10 to 15 percent in
June 2003.
Excess liquidity in the financial system, after the withdrawal of banks' deposit
lottery schemes and low interest, have played a major role in the recent improvement in
stock valuations, and some consolidation at current levels will be healthy for the market.
At the same time there is certainly a re-rating taking place based on reducing political
uncertainty, greater transparency in policies as well as improving corporate sector
fundamentals and earnings growth outlook.
On the political front, the military backed technocrat government is likely to
continue operating for the foreseeable future. From an investor perspective, the relative
stability on the political front is likely to reduce uncertainty. The GoP credibility over the
coming months is critically dependent on delivering on the promises of good governance,
accountability of corrupt elements and sustained economic revival through reforms.
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On the economic front, an Economic Advisory Board (EAB) has been constituted.
It is headed by the finance minister who is a senior banker inducted from Citibank and is
well regarded in international financial circles. The EAB is composed of eminent
economists, professionals and private sector business personalities without any political
background. It has already drawn up an exhaustive blueprint for economic reform on a
sector-by-sector basis.
A number of other positive factors, including decline in interest rates, removal of
economic sanctions, trade concessions, economic assistance extended by a number of
countries, restoration of Pakistan’s relations with the International Financial Institutions,
successful completion of the Stand by Arrangement and a new three years Poverty
Reduction and Growth Facility (PRGF) program with the IMF, Paris. Club debt
rescheduling, and Pakistan’s enhanced stature in the comity of nations after September
11, created a positive environment, which led to the resurgence in the market, gradually
picking up the bullish fervor. The bullish business trend beginning in the month of
January 2002 continued to become stronger day by day and have remained uninterrupted
till now.
The implementation of the Program revealed the deeply entrenched problem of
poor corporate governance and lack of transparency in business practices and market
transactions. Many of the frameworks put in place by the Program will be meaningless at
the operational level unless the participants adopt higher corporate governance standards.
There is an immediate need to strategically address the governance issue that seriously
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restricts development of the capital market and the economy at large. Basic rules and
regulations on market transactions, transparency on trade reporting and timely and
accurate disclosure of financial information by the issuers, are some of the fundamental
factors still missing in the capital market.
With these developments, six out of nine recommendations of the Group of Thirty
were implemented. Recommendations implemented relate to trade comparison on T+1,
full operationalization of central depository, netting system, delivery versus payment
system, T+3 rolling settlement system, and use of International Organization of Securities
Commission standards. Recommendations that have not been implemented relate to trade
comparison for indirect participants, same-day funds convention, and securities lending
through the NCSS.
The intricate design of publicly owned mutual funds, involving unusual legal
obligations and many politically influential stakeholders, was not fully understood at the
time of program formulation. Restructuring and privatizing the funds required political
consensus lacking at the time of program inception as well as substantial resources to
undertake due diligence. While events unforeseen at the time of program appraisal were
inevitable, more efforts may be needed in ascertaining potential areas of technical
difficulties and incorporating measures to resolve them. Such efforts at the initial phase
of a program’s formulation would have increased the likelihood of timely reform
execution.
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Even though these Capital Market Reforms did bring certain improvements in the
economy, however the overall effect was not so pronounced. For instance the
introduction of T+3 has developed an organized system in the economy which did not
exist earlier and has become immediately popular amongst those investors and brokers
who are willing to do fraud free transactions, while on the other hand it has also pushed
back those investors and brokers who prefer keeping little margin and contain an element
of fraud in their dealings. So along with its good side of structuring the economy and
holding on to fair businessmen prevails it has the negative effect of withdrawing
businessmen too.
The implementation process of the capital market reforms has been a gradual
process. The reform measures introduced so far by SECP are inter-linked. With the
continuous monitoring by the ADB over the years, the reforming has been a flexible
affair with changes and improvements coming along the way as unprecedented aspects of
the capital markets come up. The reforms were carried out under a difficult
macroeconomic environment and subdued investor and issuer interest. The main
achievement under the CMDP has been the establishment of an effective regulator in
SECP as well as improvements in the technological market infrastructure. Progress was
also made in improving investor protection, governance of the stock exchanges, and
development of the primary corporate debt market, as well improving prudential norms
for NBFIs. The ambitious reforms addressed some of the problems and established a
good basis for further market development. However, a number of important areas within
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the financial sector need further attention to bring about the full impact of these reforms.
In many ways, the achievements under the CMDP have been necessary but not sufficient.
The reduction in the rates of NSS and other government securities, in order to
boost the capital market, may have not been a very practical step. One of the objectives of
capital market reforms was to eliminate tax and investment policy distortions. Funds
generated through contractual savings are mostly contributed by lower and middle class
of the Pakistani society. They constitute lifetime savings of the people nearing retirement.
It has been a policy of the Government, all along, to invest these savings in a portfolio of
relatively less risky securities. Sixty percent of life fund was invested in Government and
Government-approved securities. Forty percent of the fund was invested in common
stock. Investment in common stock has been raised to fifty percent, exposing this class of
citizens to more risk. Such citizens are, by and large, risk-averse. They should not be put
to greater risk.
However, the Commission failed to take into account the people who are most
vulnerable to the reduction in interest rates, the retired and the widows who have been
directly and badly hit by this change. These people have no constant source of income
and national saving schemes was their one avenue of generating funds without any risk.
This segment of our society cannot bear to take on the risk that the stock market holds.
In accordance with the transparency measures being adopted by the SECP, the
inclusion of three Board members from the outside public in SECP, is not necessarily as
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effective as they consider it to me. The condition that they can only be bankers or
chartered accountants does not necessarily mean that this will eliminate any conflict of
interest. On the contrary, bankers have now become members of the stock exchange and
have a vested interest in the regulations affecting the equity market. Similarly, chartered
accountants are responsible for audit of accounts of various companies and thus they also
have a conflict of interest since they will be making the rules for the companies, which
are their clients.
As the stock market is at a 3 years high and breaking all records, the impact of the
reforms seem to be quite obvious. However, people tend to ignore one side of the picture
and that is the Initial Public Offering (IPO) market. The capital market reform process is
in its fifth year and so far no noticeable contribution has been made to the GDP. The
stock market in Pakistan during the last 5 years has revealed that it has failed to achieve
its primary objectives of raising capital and thereby contributing to the economic growth
of the country. The development of the capital market is considered necessary for the
economic growth of any country as it helps in resource mobilization and provides an
alternative source of finance apart from the banking system. In Pakistan, however, this is
not happening. The figures verified by the SECP confirm that stock exchanges have
merely raised fresh capital of rupees 2.0 billion during past 5 years. The number of new
listing remains a dismal single digit during the same period. The stock exchanges, in no
manner, are functioning as a productive economic agent and cannot be taken as
barometers of economic activity. The country requires fresh capital not high trading
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volumes in little scrips. No one can deny that reforms aimed at governance and
transparency of stock market will bring positive results but it is directly dependant on
economic development and macro economic stability.
Despite regulations to curb insider trading and short selling, these malpractices
are still being carried out and in some cases being assisted by the brokers. An interview
with the traders at a leading brokerage house of the country, Khadim Ali Shah Bokhari
(KASB) Securities, revealed that the phenomenal rise in the stock market at present is a
mindless drive by the investors towards greater capital gains. It is driven by speculation,
as remarked by the ex- chairman of SECP, Mr. Khalid Mirza: “The Pakistani markets
respond 90 percent to speculation and only 10 percent to economic fundamentals”. Most
of the people who are actively trading today are unconcerned about the performance of
the companies. They are all looking for fast and easy money, which is not so hard since
the market is on the rise. Commercial Banks (and other financial institutions) have also
jumped into the stock market in the hope of getting quick profits. Many of the potential
investors when interviewed, expressed their doubts on the sustenance of the current high
levels at the stock exchanges. In their opinion, the only reason they would even consider
investing in such a highly speculative and unstable market is because of its good returns
which are substantially greater and attractive than the current rates of return on bank
deposits and national saving schemes.
Hubco’s share price multiplied by four times in the year 2002. What determines
stock price? In a nutshell, it is a company’s ability to generate cash flows now and in the
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future. A company’s ability to generate cash flows depends on its (1) earning power,
present and future (2) its plans for future investments and growth (3) its quality of assets,
and (4) its quality of management. Hubco’s reports do not indicate any significant change
in these fundamentals. This is true about other companies as well, whose share prices
rose very high. However, the regulators of the stock markets in Pakistan do not give
credence to these fundamentals.
Recently the stock price of Chakwal cement rose substantially within a day
despite the fact that its factories are closed down and in fact non- existent. What was the
reason behind this rise? Daily examples can be taken from the stock exchange, which are
proof of high degree speculation and blank selling. Thus more attention is required on the
part of SECP in this regard.
The KSE-100 index rose 112 percent during the year 2002. But this steep rise is
not supported by any significant improvement in the fundamentals of the economy or the
stock market. Growth in GDP was less than 3 percent in fiscal year (FY) 2002. The SBP
General Index of share prices decreased to 106.7 in FY 2002 from 128.8 in FY 2000,
though KSE-100 index increased to 1,770.1 from 1,520.7 during the same period. It may
be added that the Karachi Stock Exchange has the highest turnover rate in the world stock
markets. The regulators and brokers proclaim it with pride, but this does not seem to a
healthy sign. It points to a highly speculative market.
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The number of companies that declared dividends decreased to 370 in FY 2002
from 470 in FY 2000. The number of companies listed on KSE is constantly on the
decline. Many companies are actually de-listing themselves. A reason for this could be
their unwillingness to pay dividend once every five years or compliance with the
disclosure regulations. The Commission should also investigate the cause behind this
trend.
Circuit breakers are now being applied if there is 7.5 percent change (plus or
minus) in price of scrip from its last closing price and trading is suspended in such a
scrip. This action is to avoid very substantial rises as well as falls in the share price and
thus ensures that the market will not crash as it has in the past. It is a positive step to
ensure capital safety to some extent and attract investors.
Another discrepancy in the regulation process is concerning the brokerage houses.
Some of the large Brokerage Houses in Pakistan, which boast of high trading volumes,
are engaged in trading themselves. Therefore, their ability to guide their clients fairly is
over shadowed by their own personal interests. They might persuade the investor to sell
when the price is low so that they can buy it for themselves. Situations like these do occur
on quite a regular basis, thus simply proving that the SECP needs to be more vigilant in
this regard.
Another thing that is badly haunting the market is “Badla.” Badla is a kind of
interest and unofficial way of lending money to encourage the people to buy shares on
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borrowed money for a very short period of time and just pay only interest plus
commission rather than entangling their total capital. As the banks encourage the
businessmen to expand their business through borrowed money in the same way, the
brokers encourage the jobbers to play in the market by borrowed money. But in the
business transaction the assets purchased by borrowed money remain in the possessions
of the borrower and the banks have nothing to do with it, but in badla transaction the
buyer gets nothing except a memo of confirmation. In bank borrowing, the borrower
obtains money physically and pays principal plus principal interest while in badla
transaction; the buyer pays difference of his purchase price and market price plus
commission.
The most negative aspect of badla trading is that one can buy huge quantity of
shares by involving a very meager amount. In actual buying the transactions is one time
and ownership of shares is transferred from seller to buyer permanently while in badla
transaction only the value of the shares is changed and ownership is shifted to buyer in
token. In short, shares trading under badla transactions are an artificial way of business
means, aiming at luring the innocent people and minting money from them. As a very
small amount of money is enters the market under badla while heavy number of shares
are traded this is the reason that it causes negative impact on the market instead of
bringing any significant and positive effects.
SECP has been unable to highlight the importance of good micro level
performance as it contributes to a sound macro level performance. In Pakistan however,
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emphasis is only on good macro reform and good governance whose focus is usually on
tax collection and administration, public service delivery, law enforcement, judiciary and
operations of public sector organizations. The assumption that once a company is
privatized, the entity will govern itself efficiently is not the key to turn around micro
levels. While actual practice has proved this assumption wrong, the pains of right sizing
also feed in to the already bad law and order situation. This issue is circular. Corporate
governance in the private sector is a subject, which remains taboo so far. Unless the vital
constituent components of the economy are turned around, macro economic prosperity
will remain a distant dream.
Capital market development is market driven and the establishment of new
exchanges (or merger of existing ones) can't be mandated but one has to create conditions
for market participants to come forward when the timing is right. No one really has a
problem with ECN. However, granting a license to one party is something that has caused
a rift between the broker community and the Commission. Further more, allowing the
ECN to trade around the clock is also something that is unfair to the other stock
exchanges. However, people in favor of ECN say that the fourth electronic stock
exchange would end the fifty-year-old monopoly of stockbrokers on the market. Traders
who cannot afford to purchase costly brokerage licenses would also be able to directly
buy and sell. It would reduce transaction costs and is also a technologically feasible idea.
If it can add value to the existing stock exchanges it should not be a bad idea at all.
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However a better course of action would have been to launch ECNs through the existing
stock exchanges.
Plans are also underway for a national stock exchange. However, due to resistance
by the stock exchanges community is definitely blocking its implementation. All the
board members of the three stock exchanges have a vested interest in the rejection of this
proposal. They fear that their control over their respective exchange will diminish and
they would instead become one of many directors of a national exchange, with no real
monopolistic power. The KSE is also reluctant in this regard since it is the most
outstanding market of the country and its personal achievements may be taken out of the
limelight since it will lose its independent identity and be incorporated into a single
entity, with the negative aspects of LSE and ISE performance cutting out on KSE’s
accomplishments.
Even though SECP employees are restricted from investing in the capital market,
they still find ways to maneuver around this regulation and trade in the name of family
members or other people. Since they are the regulators of the capital markets and are
aware of all the ins and outs of the policies likely to affect the markets, it is just another
form of insider trading, against which the SECP itself is fighting.
The T+3 system is generally criticized as the system, which has depressed the
market, but results have shown that with practice and better understanding, the investors
and members are now appreciating the system and even moving towards T+1.
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T+3 and many other reforms introduced in the market over the past four and a
half years are the practical implementation of the ADB’s proposal for developing the
capital markets. Most of these proposals have been successfully put into practice, with
only a handful of them left since Pakistan’s macro economic environment and regulatory
framework either do not allow or hamper the successful implementation of these reforms.
However, all of the objectives of CMDP have been realized. The implementation process
may not have been as easy or influential as desired by the ADB, but for an unstable
country like Pakistan, the results achieved so far have been like a blessing. Due to the
conflict of interests of the regulatory authorities and the people being regulated, the
reforms may not have been put into practice fairly and justly and in their true spirit.
Changes in the regulations came along the way to adjust the reform program according to
the need of the capital market.
No steps have been taken to upgrade the Pakistan Insurance Institute and there are
no satisfactory arrangements in the country for education and training of insurance
professionals in the insurance sector. Absence of a well-established education and
training institution for insurance is being increasingly felt by the insurance industry,
which is facing difficulties in recruiting qualified personnel and in upgrading skills and
knowledge of its employees through training.
The Securities and Exchange Commission of Pakistan (SECP) has accelerated its
drive to enhance the efficiency of the stock exchanges and ensure protection of the
interest of investors. Disclosure requirements are being made more stringent. Another
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phenomenon taking shape with the general rise seen in the stock markets is the revival of
the mutual fund industry. The funds are becoming more attractive and their portfolios
attracting new investors to capitalize upon the current trends. With the recovery of
Pakistani stock market, it is the opportune time for foreign funds to make their entry into
Pakistani stock markets. The long-term outlook is promising and the markets are giving
enough movement to pick up blue chips at attractive prices with good chances of reaping
sizable capital gains on medium to long-term basis. There is ample scope for income
funds to be launched.
The reforms introduced were necessary for bringing the stock market to the
international operational, technical and regulatory standards and, to gain and maintain the
confidence of investors as one of the best regional stock market. The primary objective of
these reforms was to enhance the confidence of the investing public, in the integrity of
the governance and operational systems in the Stock Exchanges. It is believed that after
the implementation of these reforms the Exchanges will become front line regulators. In
the long run, the onus of having and maintaining public's confidence will lie with on the
Stock Exchanges themselves.
Although many of the basic concepts and frameworks have been put in place,
meticulous work will be needed for the capital market to develop and function effectively
as a medium for channeling risk and term funds efficiently to the economy.
Implementation of the concepts and frameworks is difficult given the current capacity of
the regulator and market participants. For example, enforcement of market discipline,
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vital for winning investors’ confidence, is still limited. Insider trading and front-running
remain common practices in the stock exchanges. Enforcing market regulations will
require substantial capacity building for staff of the regulatory bodies, as will upgrading
the surveillance systems. Continued support is essential for implementing the concepts
and frameworks developed under the Program at the practical level.
5.3 CONCLUSION
In the past, the stock markets of Pakistan had been hampered by weak
infrastructure and regulatory restrictions on institutional investors who were required to
invest a large proportion of their funds in Government securities. Key market participants
such as mutual funds, insurance industry and leasing companies were prevented from
playing a full role in the capital market by constraints such as tax anomalies, a
predominance of the public sector and regulatory weaknesses.
At the behest of Asian Development Bank, SECP initiated a series of reforms
with the view to strengthen its role as a regulator of the capital market as well as to put
the country's securities market on sound footing. Momentous developments in the
regulatory framework during the past four years have not only virtually transformed the
functioning of the market as a whole but also significantly altered perceptions towards
the available risk-return tradeoffs. As a result of these measures public measures in the
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stock market has been restored to a large extent as many unscrupulous elements are
finding it difficult to function in a tight regulatory system.
Expected results of the capital market reforms have been largely realized with a
stronger regulatory framework in the capital market; effective functioning of the SECP;
updating of regulations on mutual funds; privatization of public sector mutual funds; and
enactment of a new insurance law and issuance of rules. Two public sector insurance
entities have been restructured and interest rates on the national savings were rationalized
and are being adjusted periodically based on market signals. The progressive steps taken
for enhancing efficiency and transparency of exchanges as well as risk management
measures taken over the years have helped in increasing opportunity and higher turnover
at the exchanges.
Commission officials have been able to demonstrate through a large number of
measures taken over a broad front that the SECP has been able to advise a corporate
sector and capital market that is far more responsive to needs of small shareholders and
investors. Also, the marked improvement in efficiency and effectiveness of the Company
Law Division has meant greatly improved service to the general public as evidenced by
company registrations occurring within 3 days, change registration within one day, and
name availability on line. Appointment of independent directors on the Boards of the
stock exchanges and independent non-broker Chief Executives to manage the stock
exchanges is likely to send positive signals to international investors besides creating
confidence among the investors within the country. Implementation of T+3 is a major
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achievement that, with the passage of time, has improved the efficiency and transparency
in the capital market. The observance of enhanced accounting standards, reliable audits,
institutional strengthening and capacity building of the Securities and Exchange
Commission of Pakistan (SECP) have been the hallmark of the reform program.
As a result of these measures, there has been a marked improvement in the
conditions prevailing in the capital market. The State Bank of Pakistan has driven interest
rates down over the last two years. The yield on six-month government treasury bills has
declined from 12.5 percent in July 2001, to 2 percent today. By contrast, companies in
the KSE pay an average dividend yield of 10 percent. Therefore, for many people,
investing in the equity market is the best way of making money, Along with domestic
investors; foreigners and overseas Pakistanis are now also offered every possible
incentive and opportunity to undertake investment in projects of their choice. These
reforms have made a very positive impact on the capital markets in Pakistan, which is
reflected by the figures of capital raised through stock exchanges from Rs 3 billion in
2000 to Rs 16 billion in 2003. Total turnover of shares on KSE was 36.2 billion in June
2003.
This research study therefore comes to the conclusion that the reform process
initiated by the ADB has been successful in modernizing the securities market of
Pakistan and thus providing the people with a safe and viable mode of investment,
properly regulated by different authorities. Minority interest is safeguarded and a more
fairer, efficient and regulated system with fewer constraints has been the end result. The
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reforms have been a blessing for the investment starved nation and further aim to
stimulate investment, economic growth and job creation in Pakistan.
With the recovery of the Pakistani stock market, the long-term outlook is
promising and the markets are giving enough movement to pick up blue chips at
attractive prices with good chances of reaping sizeable capital gains on medium to long-
term basis. The stock and capital market reforms will have long term impact on both the
markets and in protecting the interests of the investors. There is also ample scope for
income funds to be launched. In short, Pakistani stock markets are on the road to better
performance and efficiency. Although their volatility, an essential part of all emerging
markets, creates higher risks they also magnify the potential for higher returns for any
investor who has the patience and sophistication to participate in the growth of this
emerging market.
The stock exchanges should act as a catalytic agent to the economy. They should
provide blood to the economy i.e. capital. The direction is correct and the reforms must
continue. If to continue the reforms, people have to continue, then these people must also
continue, because unfortunately in Pakistan, if people change, policies change and that
must not be allowed to happen. There are strong lobbies against these reforms and at the
very first opportunity, they would push them back or slow them down or make them
ineffective. At the ultimate, these reforms mean to make Pakistan self-reliant and to
increase its savings rate. These mean more taxes for the government, more developmental
budget, more industries and more money allocated to education and hospitals. These
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mean to make Pakistan less dependent on foreign aid, so that it will stand in the comity of
nations with its head high and less vulnerable to international pressure.
5.4 RECOMMENDATIONS
Although, a lot has been achieved during the last 4-5 years, however there is a lot,
which still needs to be accomplished. Market forces demand a more vigorous financial
market in the country. Some measures that can be taken to improve the functioning of
capital markets in Pakistan are:
Efforts must be made to increase the depth and breadth of the market by limiting
family ownership and encouraging new industries.
To improve financial reporting and disclosure, more vigorous regulations are
required. The accounting profession should try to improve its self-regulation.
One way to ensure impartiality and remove conflict of interest of the auditor is to
allow companies to engage auditors on a non- renewable fixed term contract.
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To curb speculation and carry over trading, the Futures market needs to be
strengthened. Instead of ‘badla’ financing, the commercial banks need to be
encouraged to extend financing facility to traders.
Better regulation of insider trading is essential. The directors and senior
executives should be required to disclose their sales and purchases on a regular
basis.
Given the technical nature of issues involved in the insurance and pension
industry, absence of organized education and training facilities must be addressed
as a matter of priority.
To create flow of real capital, primary markets need to be developed. SECP
should devote part of its expertise and attention to the creation of enabling
environment for development of the primary market.
Outside directors on the stock market boards need to be those who have no
conflict of interest, and also possess requisite knowledge. Nominations from
research and academic circles could be one of the solutions.
Investors should make thorough investigations about the companies before they
buy their shares. They should not get carried away by the market manipulators.
Investing in blue chips is much easy but at the same time they should expand or
keep their investment portfolio diversified.
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Measures to popularize the stock market through effective marketing efforts.
The capital market reforms should not be implemented and left to rotate in the
economy themselves. The responsible organizations should very closely monitor them
especially any anti reforms measure should be taken care of. Also as there are still some
reforms pending or are in the process of implementation, maybe a wider outcome will be
observed later once all the reforms are made functional in the economy. Presently it is
better to clean up the mess and develop a real market that would function as financial
intermediaries in its true sense. The main lesson to be learned is that strong government
ownership is critical to the success of policy and institutional reform, and sharply focused
technical assistance projects have a better chance of success.
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